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Dear Sir,
Why is it that in this question, when calculating the free cash flow, tax is calculated on the PBIT figure instead of using the tax of 155 already given in the statement of profit or loss?And also, in the same question, when the value of the flexibility to delay is calculated using BSOP, why is the increase in value if nente calculated only using the value if the call option – 603592.
Why not using 603592 + the conventional NPV of 405?Free cash flow to the firm is the cash available for all lenders – debt and equity – and is discounted at the WACC.
Therefore, just as with normal project appraisal, we ignore interest payable when setting up the cash flows and the tax saving that results from the interest. The interest and the tax saving on it is accounting for in the WACC (when calculating the cost of debt).With regard to the option, when it is an option to delay, the value of the option is the full value of the project including the option.
Perhaps the easiest way of explaining is that if you look at the formula, it is essentially
Pa – Pe (all the other ‘bits’ such as N(d1) etc. are there to deal with the uncertainty and the timing). This is effectively the normal NPV and introducing the extra bits like std deviation are giving the NPV when there is the option.(It may be that you have seen a much older past exam question where the examiner did add the value of the option to the base NPV (I think it was called Digunder). However that was the previous examiner and the current examiner has accepted that the answer was wrong!!)
Thank you sir. Just to confirm, that means whenever BSOP is used to value a project (whether to delay/expand/abandon) the value calculated using the equation includes the NPV without the flexibility as well as the value due to the flexibility right?
No, and I apologise because I should have clarified this in my previous reply.
It is only when it is an option to delay that the value from the formula is the full value of the project including the option.
For other options (expand/abandon) the value from the formula is just the value of the option and is in addition to the NPV of the project.
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