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Hello John.
I want to ask if initial requirement of projects is not computed into PV when calculating Pa(underlying asset of real option). Referring to the example in your lecture on chap 14, you’ve mentioned that total NPV of future cash flow is 12 mil, since NPV is 2 mil and initial outlay will be returned subsequently in the exact amount. However, isn’t initial requirement supposed to be discounted down to the present value too? I don’t understand why only operating cashflow is concerned when calculating total asset value in BSOP model.Thank in advance.
Subtracting the initial outlay would give the NPV. For the BSOP formula it is the PV of the future flows that is relevant.
This is nothing to do with the initial outlay being returned subsequently in the exact about (which is very unlikely to be the case anyway).
The net present value is the present value of the future flows less the initial outlay.
The PV of the future flows is the value of the investment which is what is relevant when calculating the option value. Think about it – if the cost of an investment is 10M and the PV of the future flows is 12M, then if there was an option that was exercisable today it would be worth 12 – 10 = 2M. i.e. Pa – Pe.
The other terms in the formula are taking account of the fact that the option is exercisable on a future date, and on the future date the PV of the future flows is likely to be different.I think now I got this right. It’s a huge shame, but I was forgetting about a concept of NPV and also, an initial outlay. I was mixing it up with working capital.
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