Discussion Issues and Derivations

  1. What is the cost of using excess capacity?
    Firms often use the excess capacity that they have on an existing plant, storage facility or computer resource for a new project. When they do so, they make one of two assumptions:
    1. They assume that excess capacity is free, since it is not being used currently and cannot be sold off or rented, in most cases.
    2. They allocate a portion of the book value of the plant or resource to the project. Thus, if the plant has a book value of $ 100 million and the new project uses 40% of it, $ 40 million will be allocated to the project.
    We will argue that neither of these approaches considers the opportunity cost of using excess capacity, since the opportunity cost comes usually comes from costs that the firm will face in the future as a consequence of using up excess capacity today. By using up excess capacity on a new project, the firm will run out of capacity sooner than it would if it did not take the project. When it does run out of capacity, it has to take one of two paths:
    &Mac183; New capacity will have to be bought or built when capacity runs out, in which case the opportunity cost will be the higher cost in present value terms of doing this earlier rather than later.
    &Mac183; Production will have to be cut back on one of the product lines, leading to a loss in cash flows that would have been generated by the lost sales.
    Again, this choice is not random, since the logical action to take is the one that leads to the lower cost, in present value terms, for the firm. Thus, if it cheaper to lose sales rather than build new capacity, the opportunity cost for the project being considered should be based on the lost sales.
  2. How should we treat product cannibalization in capital budgeting?
    Product cannibalization refers to the phenomenon whereby a new product introduced by a firm competes with and reduces sales of the firm’s existing products. On one level, it can be argued that this is a negative incremental effect of the new product, and the lost cash flows or profits from the existing products should be treated as costs in analyzing whether or not to introduce the product. Doing so introduces the possibility that of the new product will be rejected, however. If this happens, and a competitor now exploits the opening to introduce a product that fills the niche that the new product would have and consequently erodes the sales of the firm’s existing products, the worst of all scenarios is created – the firm loses sales to a competitor rather than to itself.
    Product Cannibalization: These are sales generated by one product, which come at the expense of other products manufactured by the same firm.
    Thus, the decision whether or not to build in the lost sales created by product cannibalization will depend on the potential for a competitor to introduce a close substitute to the new product being considered. Two extreme possibilities exist: the first is that close substitutes will be offered almost instantaneously by competitors; the second is that substitutes cannot be offered.
    -If the business in which the firm operates is extremely competitive and there are no barriers to entry, it can be assumed that the product cannibalization will occur anyway, and the costs associated with it have no place in an incremental cash flow analysis. For example, in considering whether to introduce a new brand of cereal, a company like Kellogg’s can reasonably ignore the expected product cannibalization that will occur because of the competitive nature of the cereal business and the ease with which Post or General Food could introduce a close substitute. Similarly, it would not make sense for Compaq to consider the product cannibalization that will occur as a consequence of introducing a Pentium notebook PC since it can be reasonably assumed that a competitor, say IBM or Dell, would create the lost sales anyway with their versions of the same product if Compaq does not introduce the product.
    - If a competitor cannot introduce a substitute, because of legal restrictions such as patents, for example, the cash flows lost as a consequence of product cannibalization belong in the investment analysis, at least for the period of the patent protection. For example, Glaxo, which owns the rights to Zantac, the top selling ulcer drug, should consider the potential lost sales from introducing a new and maybe even better ulcer drug in deciding whether and when to introduce it to the market.
    In most cases, there will be some barriers to entry, ensuring that a competitor will either introduce an imperfect substitute, leading to much smaller erosion in existing product sales, or that a competitor will not introduce a substitute for some period of time, leading to a much later erosion in existing product sales. In this case, an intermediate solution, whereby some of the product cannibalization costs are considered, may be appropriate. Note that brand name loyalty is one potential barrier to entry. Firms with stronger brand name loyalty should therefore factor into their investment analysis more of the cost of lost sales from existing products as a consequence of a new product introduction.
  3. When is the option to delay a project a valuable option?
    The option to delay a project is valuable if and only if the following conditions are met:
    1. The firm has exclusive rights to the project for a fixed period. If it does not have exclusive rights in a competitive sector, the project will be taken be a competing firm as soon as it becomes a value-creating project. In other words, the option will be exercised by someone else as soon as S>K.
    2. There have to be factors that will cause the present value of the cash flows from taking the project (eg. technological or market shifts) to vary across time. If there is no variance in the present value of the cash flows, there can be no value to the option.
  4. When is the option to expand a project a valuable option?
    The option to expand a project adds value to the current project if and only if the following conditions are met:
    1. The current project has to be taken in order for the expansion to be viable later on. In other words, if the firm can take the expanded version of the project later without taking the current project, it is not appropriate to credit the current project with the value of this option. In real world projects, the current project may provide either the information that is necessary to make the expansion decision, or the brand name visibility and technical skill that is required for the expansion to work.
    2. There have to be factors that will cause the present value of the cash flows from expansion to vary across time. If there is no variance in the present value of the cash flows, there can be no value to the option.
  5. The Right Option Pricing Model to Use in Valuing Real Options
    We have used the Black-Scholes European option pricing model to value the options in the book. The high likelihood that these options will be exercise early make the binomial model (which allows for early exercise) or a Black-Scholes model designed to value American options a more appropriate choice. Note, however, that the European option pricing model will provide a conservative estimate (too low) of the option value. Early exercise considerations will only make this option more valuable.
  6. Are strategic considerations valuable options?
    Many firms, faced with projects that do not meet their financial benchmarks, use the argument that these projects should be taken anyway because of "strategic considerations". In other words, it is argued that these projects will accomplish other goals for the firm or allow the firm to enter into other markets. There are cases where these strategic considerations are really referring to options embedded in projects - options to produce new products or expand into new markets.
    The differences between using option pricing and the "strategic considerations" argument are the following:
    1. Option pricing assigns value to only some of the "strategic considerations" that firms may have. It considers cases where the initial investment is necessary for the strategic option (to expand, for instance), and values those investments as options. However, strategic considerations that are not clearly defined or include generic terms such as "corporate image" or "growth potential" may not have any value from an option pricing standpoint.
    2. Option pricing attempts to put a dollar value on the "strategic consideration" being valued. As a consequence, the existence of strategic considerations does not guarantee that the project will be taken.