Textel Systems, Inc.

January 2011 Rajiv D. Banker

FVTB Session 9

Textels Decision Tree

(Invest $ 40m)

High
p Invest ($8m) $ 18.9 m Do Not Invest

1-p

Low $ 8.4 m

(Invest $ 40m)
Do Not Invest

Invest

($5m) Do Not Invest

2

Rajiv D. Banker

Upside Probability in 2006 for Second Generation MSBMS

18.9p + 8.4(1-p) = 10.5 (18.9 8.4) p p = 2.l / 10.5 Therefore, p = 0.20 1-p = 0.80
The most likely scenario is the downside!
Rajiv D. Banker
3

= 10.5 8.4

Importance of Experience with First Generation MSBMS

Supports multiple services Designed to be scalable and evolve with changing technology Forward compatibility with potential second generation technology
4

Rajiv D. Banker

Cash Flows for First Generation MSBMS Without Upgrading

2003 EBIT Tax Paid Depreciation Cap. Exp. Inv. in Wkg. Cap. $ (2.200) $ $ $ $ $ 2004 1.200 0.800 $ 2005 2.000 $ 2006 3.200 2007 $ 2.200 2008 $ 0.400 $ (0.350) $ (1.120) $ (0.770) $ (0.120) $ $ $ 0.800 $ $ $ 0.800 $ 0.800 $ $ $ 0.800 $ -

$ (4.000) $ $ (0.500) $

$ 0.500

Free Cash Flow

$ (6.700) $

2.000

2.450

2.880

$ 2.230

$ 1.580

Discount Factor Present Value

1.000

0.833 1.667

$ $

0.694 1.701

$ $

0.579 1.667

$ 0.482 $ 1.075

$ 0.402 $ 0.635
5

$ (6.700) $

Rajiv D. Banker

Net Present Value = ($0.044 million)

Cash Flows for First Generation MSBMS With Upgrading

2003 EBIT Tax Paid Depreciation Cap. Exp. Inv. in Wkg. Cap. $ (2.600) $ $ $ $ $ 2004 1.000 0.960 $ $ $ $ $ 2005 1.600 0.960 $ 2006 4.000 2007 $ 2.000 2008 $ 0.615 $ (1.400) $ (0.700) $ (0.215) $ $ $ 0.960 $ 0.960 $ $ $ 0.960 $ -

$ (4.800) $ $ (0.600) $

$ 0.600

Free Cash Flow

$ (8.000) $

1.960

2.560

3.560

$ 2.260

$ 1.960

Discount Factor Present Value

1.000

0.833 1.633

$ $

0.694 1.778

$ $

0.579 2.060

$ 0.482 $ 1.090

$ 0.402 $ 0.788
6

$ (8.000) $

Net Present Value = ($0.652 million)

Rajiv D. Banker

Second Generation MSBMS

NPV of first generation MSBMS is small positive (= $0.44m), but upgrading has negative NPV (= - $0.652) Minimum expected value of second generation to justify upgraded first generation investment should = ($0.652 + $0.044) million = $ 0.696 million
7

Rajiv D. Banker

Present Value of a Five Year Annuity

Present Value @ 25%

Year 1
Year 2 Year 3 Year 4 Year 5 Annuity value:
Rajiv D. Banker

0.8000
0.6400 0.5120 0.4096 0.3277 2.6893
8

Expected Present Value of Second Generation MSBMS

PV in 2006 of Expected Cash Flows
= $ 10,500 * 2.6893

= $ 28.238 million
Additional investment = $ 40.000 million

Ex ante expected value = ($ 11.762 million)

9

Rajiv D. Banker

Conditional Present Value Based on New Information

PV in 2006 of Upside Cash Flows
= $ 18.900 * 2.6893 = $ 50.828 million which exceeds the investment of $ 40 million PV in 2006 of Downside Cash Flows = $ 8.400 * 2.6893 = $ 22.590 million which is less than the investment of $ 40 million
Rajiv D. Banker

10

Incremental Value of Second Generation Investment Option

Incremental expected present value of optimal decisions discounted from 2006 to 2003
= [0.20($ 50.828 - $ 40.000) + 0.80($ 0) ]* 0.579 where 0.579 is the discount factor @ 20% = $ 1.254 million Observe that the value of the option is substantial even when the expected value of the second generation (if committed in advance) is negative 11
Rajiv D. Banker

NPV of the MSBMS Project

NPV = ($ 0.652) + $ 1.254 million

= $ 0.602 million
Many IT projects can be justified only because of their option value Upgrading is worthwhile only if the second generation option is recognized.
12

Rajiv D. Banker

Likelihood of MSBMS Growth

Access networks are required for data communication technology Businesses and consumers will demand greater and better connectivity MSBMS provides a scalability option MSBMS is designed to be forward compatible
13

Rajiv D. Banker

Availability of Lead Indicator

Can observe whether the first generation MSBMS is accepted for data services market Substantial investment in the second generation is required only after this signal is observed A more reliable lead indicator increases the value of the real option.
14

Strategy for MSBMS Plan for the Best Case!

Detailed analysis of the competitive strategy for the second generation does not seem to have been conducted Since investment in the second generation will be made only under the favorable scenario, Textel should identify actions that will maximize profit under the favorable scenario (and not the most likely scenario)
15

Rajiv D. Banker