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examples.

The first concerns flexibility which is considered to be part of the â€˜me tooâ€™

return. It does not matter how much effort one puts into calculating this

if one is only then going to assume that the â€˜me tooâ€™ player has a negative

NPV equal to 10% of its capex. Second, the value of subsequent growth is

not crucial if one already knows that the initial investment will earn at least

the CoC. My third example concerns flexible uses for an asset. There is, for

example, enhanced value when ordering a new aeroplane if one knows that it

can operate on, say, three major routes, not just one. If, however, one is con-

tent that it is worth committing to an order just on the basis of the potential

demand from one main route then the additional flexibility value may be an

interesting fact, but it is not really crucial to know what it is worth.

Even when one is doing flexibility valuations it can pay to manage the effort

which is put into them. So, if we return to my ethylene demand example, one

might be able to avoid some valuations if one knew the result of another

study. If, for example, we decide to build a large cracker and a pipeline to

the market, then the study concerning demand for the downstream product

would not be necessary.

491 Second view: Valuing flexibility

Step 8: Apply appropriate tool from the toolkit to value the flexibility

We are now ready to meet my suggested list of tools for valuing flexibility.

This is as follows:

A. More sophisticated assumptions

B. Risk monetisation

C. Growth value

D. Valuing the tail

E. Monte Carlo simulation

F. Simple decision trees

G. Reverse engineering

H. Black-Scholes

I. Analogy

J. Include any additional costs

I will now explain each of these. In most instances I believe that the descrip-

tion which is provided in this book should allow a practitioner who is skilled

in basic economic value techniques to complete a flexibility valuation. I will

highlight those limited situations where I believe that additional specialist

assistance is needed in order to carry out a flexibility valuation.

Step 8A: More sophisticated assumptions

This first approach is so simple that I sometimes wonder why I have to intro-

duce it as a technique in the advanced section of this book! I need to do

this, however, because my experience tells me that many practitioners do not

realise the implicit assumption which they are making when they carry out

a valuation. The more sophisticated assumptions approach simply involves

making more refined assumptions than are usually made in an economic

value calculation. In particular the approach requires that one rejects the use

of annual averages.

The usual approach in an economic value calculation is to project annual

cash flow through a series of calculations which are typically of the form:

sales revenue = sales volume Ã— sales price.

Sales volume and sales price are annual averages. Companies will often, in

effect, mandate this approach by specifying a central set of assumptions for

their key products and raw materials. There is no problem with this approach

if your project is producing a single product that is sold at a steady rate

throughout the year. It can, however, miss a lot of potential value creation if

492 Three views of deeper and broader skills

your project brings with it the inherent flexibility to change things through-

out the year.

Consider any of the following situations:

â€¢ you anticipate that there may be times during a year when you will shut

down your plant because the marginal contribution would be negative;

â€¢ you expect to judge the timing of your purchasing of raw materials in order

to buy at a better than average price;

â€¢ you expect to judge the timing of your sales such that you sell at a better

than the average price;

â€¢ you have the flexibility to switch feedstock in response to market

movements;

â€¢ you have the ability to change the output of your plant.

These will all allow a company to create more value than would be implied

by the use of simple annual average assumptions and on some occasions the

effect can be quite significant. Now I would suggest that most projects will

anticipate doing at least some of the above. In all of these situations, there-

fore, one will not capture the benefit of the flexibility if one applies a simple

annual approach. One can start with the annual average and then, I suggest,

add a little sophistication to the assumptions in order to capture more accu-

rately what will, in reality, happen.

I will consider first the ability to shut down production when the mar-

ginal contribution goes negative and illustrate the effect with a simple

example.

Suppose that a company is investigating the purchase, for $700,000, of a

manufacturing machine that makes bathtubs. The company expects to have

sales of 10,000 bathtubs per year and each unit sells for $100. Variable costs

are $80 per unit and cash fixed costs are $100,000 per annum. We will ignore

working capital, inflation and tax and assume a ten-year project life and a

CoC of 9%. The financial model which we use can be very simple and is as

follows:

$

Sales revenue 1,000,000

Variable costs (800,000)

Fixed costs (100,000)

Annual cash flow 100,000

Annuity factor (mid-yr flows) 6.700

Present value cash inflows 670,000

493 Second view: Valuing flexibility

The project has an NPV of $(30,000). The IRR is almost exactly 8%. Faced

with this prospect the logical reaction would be to decline the investment

opportunity.

Now let us introduce the potential for shutting down production when the

marginal contribution is negative. If the variable costs remain the same but

the selling price is variable we would shut down production whenever prices

fell below $80 per unit. So if we thought that selling prices would never fall

below $80 per unit the flexibility to shut down production would, based on

this assumption, have no value.

Suppose, however, we thought that a more realistic set of price assump-

tions was that the selling price would be in the range $70â€“130 per unit with

the lower figure prevailing for 20% of the time, the mid point for 60% of the

time and $130 for 20% of the time. What would be the implications of this for

the potential NPV of our project? We would still face the same average selling

price over the year of $100 per unit but our company would not sell through-

out the year. We would only produce during the period when the price was

$100 or $130 per unit. The overall sales volume would be lower but the result

would be better. Our revised financial projection would be as follows:7

$

Sales revenue7 860,000

Variable costs (640,000)

Fixed costs (100,000)

Annual cash flow 120,000

Annuity factor (mid-yr flows) 6.700

Present value cash inflows 804,000

The project now offers a positive NPV of just over $100,000. The source of

this additional $134,000 of value is the decision to cease production when

prices are low and our assessment of how often this occurs. This flexibility

allows us to avoid a negative contribution of $10 per unit on sales of 2,000

bathtubs. The present value of $20,000 per year for ten years is $134,000.

At present these are just a set of assumptions and the answer is only ever

as good as the assumptions on which it is based. The decision-maker would

need to convince himself that he was content with the assumptions. Was it

realistic, for example, for our company to move in and out of the market

when we wanted to? This suggests that customer relationships were of no

Calculated as 6,000 Ã— $100 + 2,000 Ã— $130 = $860,000.

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