Question 20.2: The Value of Real Options SITUATION: You work for a company ...
The Value of Real Options
SITUATION: You work for a company that manufactures cardboard packaging for consumer product companies under long-term contacts. For example, your company manufactures the boxes for several popular cereal and aspirin products. You have just won a large five-year contract to produce packaging materials for a company that sells furniture on the Internet. Since this contract will require you to produce much larger boxes than you currently can produce, you must purchase some new equipment. You have narrowed your choices to two alternatives. The first is a capital-intensive process that will cost more up front but will be less expensive to operate. This process requires very specialized equipment that can be used only for the type of packaging that your furniture client needs. The second alternative is a labor-intensive process that will require a smaller up-front investment but will have higher unit costs. This process involves equipment that can be used to produce a wide range of other packages. If the expected life of both alternatives is 10 years and you estimate the NPV to be the same for both, which should you choose?
DECISION: You should choose the labor-intensive alternative. Your contract is only for five years, and there is a chance that it will not be renewed before the equipment’s useful life is over. If the contract is not renewed, it will be easier to convert the labor-intensive equipment to another use. In other words, the labor-intensive alternative gives you the added value of having the option to abandon producing packaging for furniture.