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Hi John,
I watched your video on real options and was a little bit confused towards the end. So the initial project had an NPV of $2m and the option to delay had an NPV of $3.9 I think.
I thought if the option to delay was applied it would have meant the initial option of doing the project now has been allowed lapse because there is a better option when the project is delayed. So why do we have to add the NPV value of doing the project now to doing the project in 3 years time. Is it that if you were to do the whole NPV for the project plus another 3 years you would get an NPV of $5.9m?
Many Thanks
Two things.
Firstly, without the option to delay you either do the project or you don’t. If it has a positive NPV then you would do the project, but you would have to do it even though you are uncertain about the flows that will occur.
If on the other hand the option to delay exists, then you can obviously still do the project but can wait until you are more certain about the cash flows (and if they turn out to be worse then decide not to do it).
So having that option is worth more than not having it.
Secondly, I do need to re-record this lecture. It was based on a real exam question (the first time that real option calculations had been asked) and did it the same way as the examiner did in his answer. However, recently the current examiner has said that it was wrong.
If the NPV of the project without the option is $2, and the value with the option is $3.9M, then the value of the option is the extra $1.9M (not $3.9M)Thanks John. that really helps. I’m about to try an a question which looks like the exam question you mentioned called DIGUNDER. I’ll let you know how it goes.
Thanks 🙂
hi Sir, i refer to your reply above, u mentioned that recently the current examiner has said that it was wrong.
can you advise which article / examiner report can we refer to in order to get the most correct answer? because i am using bpp text book it seem liked haven’t amend it.
i am a bit confuse with the real option so that i hope can refer to correct answer/ article
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