Topic ONE Real Options Question ONE The managers at Greenwich have been asked to comment on the following investment opportunity. This is seen as a particularly difficult decision as the economic outlook for next year is difficult to forecast.

Investment cash flows:
Year 1 Year 1 Year 2 Year 2
Cash flow Probability Cash flow Probability
Base
Scenario £110,000 0.7 £90,000 0.2
£100,000 0.6
£110,000 0.2
Optimistic
Scenario £120,000 0.3 £110,000 0.2
£120,000 0.4
£150,000 0.4

The base scenario assumes that cash flows in Year 2 will be in the range of £90,000 - £110,000. The optimistic scenario 2 assumes cash flows will be higher in Year 1 and this will result in higher cash flows in Year 2. For both scenarios the Year 2 cash flows are therefore dependent on the Year 1 cash flows.

Investment required is £190,000. Discount rate for this investment = 10%

Abandonment value - A competitor is willing to offer £110,000 for the assets at the end of Year 1.

Required:

(a) Determine the value of the option to abandon for this investment and advise managers whether or not the investment should be approved. (18 marks)

(b) Recent surveys suggest the majority of managers do not use Real Options Analysis as part of the capital budgeting process. Identify and evaluate the reasons why managers are not using Real Options.