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Â Last time, we talked about some of the risk factors that companies face

Â while implementing a project.

Â These affect the cash flows and possibly the attractiveness of the project.

Â The traditional NPV analysis we have seen so far as used,

Â that decisions can not be the worst.

Â For example, you accept a positive NPV project today, but due to some unforeseen

Â circumstances, a year later the project is no longer attractive.

Â NPV analysis doesn't account for such outcomes.

Â We have what are called real options,

Â which help bring in flexibilities to projects.

Â In this video, we will talk about these flexibilities and

Â try to understand them better.

Â Traditional NPV analysis assumes that a positive NPV project cannot be shutdown or

Â abandoned if it is found to be unprofitable later on.

Â Similarly, rejecting a negative NPV project today means that

Â the investment opportunity is lost forever.

Â A project may not be profitable today, but

Â may become viable a couple of years down the line.

Â We could always revisit our NPV analysis at that point

Â once more information about the project's viability becomes available.

Â The whole idea of real options is that it allows us to revisit or reconsider our

Â decision to accept or reject a project once more information becomes available.

Â This information should resolve some of the uncertainty related to the project,

Â otherwise the flexibility of the real option is worthless.

Â The easiest way to calculate the value of an option is to calculate the NPV

Â with the option included and also calculate the NPV without the option.

Â The difference between the two values is the value of the option.

Â Let's look at the simple example to understand how to value a real option.

Â Our company says that there is a 50% chance that a new product will have a high

Â demand and generated $1 billion in profits.

Â Another 50% chance that demand will be low,

Â which generates negative $150 million in profits.

Â For simplicity, let's assume that these numbers are already in present

Â value terms, and so no further discounting is necessary.

Â The expected NPV of this project is 0.5 * 1 billion +

Â 0.5 * -150 million which equals $425 million.

Â The uncertainty here is whether demand for the new product will be high or low.

Â Let's say that there is a proposal to spend $4 million on a market survey study.

Â Running a market survey study will help resolve uncertainty as to whether demand

Â will be high or low for the product.

Â If the study finds that the demand will be high then the company

Â will launch the product and earn $1 billion profits.

Â On the other hand if the study finds that demand will be low

Â it is better off not launching the product.

Â Not launching the product will give the company profits of $0.

Â What is launching when demand is focused to be low

Â really losses of 150 million dollars.

Â So, it doesnâ€™t make sense for

Â the company to launch the product if demand is estimated to be low.

Â The expected NPV of the project with the cost of the marketing research

Â study included is negative 4 million Plus 0.5 * 1 billion + 0.5 * 0,

Â which works out to $496 million.

Â The value of the option is $496 million- $425 million, which is $71 million.

Â Doing the marketing study increases the project's value by $71 million.

Â And hence, the company must invest in the market research study to

Â resolve the uncertainty on the market.

Â To understand the idea of the flexibility better,

Â let's change the profits when demand is low to a positive $100 million,

Â instead of the earlier negative $150 million.

Â 3:33

Launching a product without doing the study adds an additional 0.5 * 1 billion +

Â 0.5 *100 million which is $550 million.

Â On the other hand, the value of lodging after doing the study is -4

Â million + 0.5 * 1 billion + 0.5 * 100 million which is 546 million.

Â Notice in this case, that since the profit is under bought high and

Â low demand are positive, we will always launch, so there is no uncertainty.

Â Which is why the value of the project without the study

Â is higher than the value of the project with the study.

Â In other words, not having any uncertainty,

Â the result makes the marketing study useless.

Â These real options and flexibilities are valuable only if there is some uncertainty

Â and they help in resolving this uncertainty.

Â They have no use and has no value if there is more uncertainty, or

Â they do not resolve any uncertainty.

Â Let's go back to our example of the FMCG firm looking at the business intelligence

Â platform.

Â There we found that when sales were high,

Â the project NPV was a positive $510,770 and

Â when sales were low, the project NPV was a negative $934,007.

Â Let's introduce a flexibility under which the firm can shut down the business

Â intelligence platform in the first year, if revenues are found to be low.

Â If it shuts down the platform, it will be able to recover 80% of

Â all its year zero investments, except for the training cost.

Â This means, it'll recover 80% of 500,000 + 200,000 +

Â 125,000- 180,000 and get 516,000.

Â Given the negative FCF in the first year as well as subsequent years, it is better

Â to shut down the platform if renews are falling below in the first year.

Â In this case the MPV of the project, if revenue are low in the first year.

Â [INAUDIBLE] cash flow of -580,000 + 516,000-

Â $26,750 discounted back one year at 15%,

Â this comes out to a negative $154,565.

Â Calculating the expected NPV which is

Â 0.05 * -154,565 + 0.05 *

Â 510,770 we get $178,102.

Â Given the positive NPV with the value to shutdown the platform if demand is low,

Â the CEO now should decide to accept the project.

Â The value of this option to shut down is the difference with the NPV with and

Â without the option which is 178,102- -211,618 which is $389,721.

Â So having flexibilities to change our decisions

Â help arrive at better outcomes for shareholders.

Â Hence, we must not ignore these flexibilities when we value projects and

Â calculate NPVs.

Â This brings us to the end of the course.

Â Companies usually view various IT investments as flexibilities or

Â real options.

Â Revisiting decisions to accept or reject investments in IT

Â will make them more attractive to the manager as well as shareholders.

Â As part of understanding and valuing these flexibilities,

Â we looked at a number of basic concepts in accounting and finance.

Â I hope you enjoyed the course as much as I did bringing it to you.

Â Goodbye.

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Â