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Zealand economy, the exchange rate between the Indian rupee and New
Zealand dollar is also a source of uncertainty. The company has examined
alternative scenarios and come up with the possibilities shown in exhibit
A.20.1. The firm can liquidate the plant at the end of year 1 for a salvage
value of NZD 12 million
Exhibit A.20.1
Exchange Rate and Net Cash Flow Scenarios
Year 1
Year 2
(31.8125, 30.0)
(27.5, 20.0)
(24.0625,25.0)
(24.0625,10.0)
(17.5, 10.0)
(15.3125,7.0)
In each pair of numbers in the parentheses the first number corresponds to the
NZD/INR exchange rate and the second to the net cash flow from the plant in
millions of NZD. The current spot rate is INR 20.0 per NZD. Thus in year 1, the
exchange rate may go up to 27.5 with the net cash flow being 20.0 million NZD
or, the exchange rate may plunge to 17.5 and then the cash flow will be 10.0
million NZD. Both outcomes are equally likely with 50% probability of
occurrence. Given the outcome in year 1, in year 2 again there are two equally
likely possibilities; thus if in year 1, boom conditions prevail, the exchange rate
may further rise to 31.8125 with the net cash flow rising to 30.0 million or the
economy may slow down with the exchange rate falling to 24.0625 and the net
cash flow to 25.0 million. If the economy is depressed in year 1, the year 2
outcome may be (24.0625, 10.0) or (15.3125, 7.0), each with probability 50%.
We will first determine the expected net present value of acquiring the brewery
without considering the abandonment option.
The four possible scenarios, the rupee net cash flows under each and the NPV of
these cash flows are shown in exhibit A.20.2
Exhibit A.20.2
Project NPV without Abandonment Option
________________________________________________________
Net Cash Flows
(Million Rupees)
Total
Scenario
Year 0
Year 1
Year 2
NPV
Probability
(Mill.Rs.)
________________________________________________________
I
-300
550
954.38
899.93
0.25
II
-300
550
601.56
633.15
0.25
III
-300
175
240.63
34.13
0.25
IV
-300
175
107.19
-66.77
0.25
_________________________________________________________
To obtain the expected NPV of the acquisition, multiply the total NPV under
each scenatio by the probability of that scenario and sum across all the
scenarios :
(899.930.25) + (633.150.25) + (34.130.25) - (66.770.25) = 375.12
Now let us incorporate the abandonment option. If the economy is depressed in
year 1 with the exchange rate at 17.5, the firm can sell off the plant at a net
salvage value of NZD 12 million thus sacrificing the cash flow of the second
year. The NPV calculations are now as shown in exhibit A.20.3
Exhibit A.20.3
Project NPV with Abandonment Option
________________________________________________________
Net Cash Flows
(Million Rupees)
Total
Scenario
Year 0
Year 1
Year 2
NPV Probability
(Mill.Rs.)
________________________________________________________
I
-300
550
954.38
899.93
0.25
II
-300
550
601.56
633.15
0.25
III
-300
385
---34.78
0.50
_________________________________________________________
If the economic conditions in year 1 are depressed, the firm gets a net cash flow
of Rs.175 million from operations and Rs.210 million from sale of the assets for
a total net cash flow of Rs.385 million in year1. The expected NPV of the project
is now
(899.930.25) + (633.150.25) + (34.780.50) = 400.66
Thus the possibility of abandoning the project after one year increases the
expected NPV by over Rs.2.5 crores making the project more attractive.
This highly simplified example serves to illustrate the importance of
incorporating such built-in operational flexibility in the appraisal process. In most
real life situations, many more options may be available- timing of investment,
expanding or contracting the scale, temporary closure or abandonment and so
forth- and some of them are inter-related in complex ways. The option pricing
approach can be fruitfully employed in some of these cases.