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Hello John,
I find confusing the different approaches used in the exercises Wit and Pratney and MMC (Revision Kit) to determine whether a company should proceed with the project using BSOP model. Both exercises require to estimate value of call option.
In Wit and Pratney the PV of development cost $664.4m is deducted from the value of development call option $1,145.6 to estimate the value of development opportunity. This makes sense to me.
But in MMC the NPV ($2.98m) of the project (icl.development and production stage) is deducted from the value of option to delay to determine the acceptance of the project… I am confused… This doesn’t make sense to me so far…
I guess, the value of option to delay $9.529m should be compared to the project’s NPV ($2.98m), rather than reduced by this amount.
In addition to that, it looks that the development costs ($7m+$6.31m=$13.31m) are ignored estimating the entire opportunity to delay the project. In other words, the value of option to delay needs to be reduced by the development cost and compared to the NPV of project without option to delay:
NPV of project with option to delay: $9.529m – $13.31m=($3.781m)
NPV of project without option: ($2.98m)
both results are negative, so the project should not be accepted.… not sure I’m correct…
Could you please comment on this.One more thing I need your help with –
Wit and Pratney:
12 year annuity is used to discount the production cash flow.
Why not 15 years? The project is for 15 years including development phase, the production commences in 3 years for 12 years, so annuity years 15-4 can be relevant to discount the production cash flow.Thank you!
In MMC, the option is only to delay the decision about production and marketing. So whatever happens they will still be paying the development costs. It is simply that at the end of the two years they will then be able to choose whether or not to continue and pay the other costs.
We don’t compare the two NPV’s. If they do not have the option, then the NPV is $(2.98M).
The option itself is worth something ($9.529M) and therefore with the option, the value of the project is higher at 9.529 – 2.98With regard to your annuity question.
I do not have the Wit and Partner question (it is not in the current edition of the BPP Revision Kit).
However if the first flow is in 4 years time, and there are 12 flows, then it is 4 to 15.
There are two ways of arriving at the same answer.You can either use the 12 year annuity factor (because there are 12 years of flows) and then multiply by the ordinary 3 year factor (because the annuity starts 3 years late (at time 4 instead of time1).
Or alternatively, you can take the 15 year annuity factor and subtract the 3 year annuity factor – this will leave a total factor for 4 to 15.
Both ways give the same result (actually they are slightly different because the tables are rounded to 3 decimal places, but that is irrelevant – especially since usually we take the flows to the nearest thousand $’s anyway 🙂 )
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