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

while implementing a project.

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

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

that decisions can not be the worst.

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

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

NPV analysis doesn't account for such outcomes.

We have what are called real options,

which help bring in flexibilities to projects.

In this video, we will talk about these flexibilities and

try to understand them better.

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

abandoned if it is found to be unprofitable later on.

Similarly, rejecting a negative NPV project today means that

the investment opportunity is lost forever.

A project may not be profitable today, but

may become viable a couple of years down the line.

We could always revisit our NPV analysis at that point

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

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

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

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

otherwise the flexibility of the real option is worthless.

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

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

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

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

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

demand and generated $1 billion in profits.

Another 50% chance that demand will be low,

which generates negative $150 million in profits.

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

value terms, and so no further discounting is necessary.

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

0.5 * -150 million which equals $425 million.

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

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

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

will be high or low for the product.

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

will launch the product and earn $1 billion profits.

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

it is better off not launching the product.

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

What is launching when demand is focused to be low

really losses of 150 million dollars.

So, it doesn’t make sense for

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

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

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

which works out to $496 million.

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

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

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

resolve the uncertainty on the market.

To understand the idea of the flexibility better,

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

instead of the earlier negative $150 million.