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BPP dec.2012
Hi john I am a bit confused regarding requirement b(i)
BSOP model
Why the answer has compared the value of real option with the present value of the development cost?Why cant we just find the NPV and add the value of the real option to find out if it is worthwhile to pursue the project.
What type of real option is it? My guessing is option to delay or expand or if any other please elaborate kindly.
Normally we find the NPV and the add the value of real option to the npv to find out the overall value?
Is there any shortcut ways i can find out the PV of future cash inflows from the project by adjusting the inflations to the cash inflows.I think BPP answers are treating them seperately because they have used real rate to find the PV of cash inflows and nominal discount rate to discount the development cost.BUt if we inflate the cash inflows by 4% some how as i dont know how to inflate it for 12 years but if i want to do it on time line it just would be to big than can we use the nominal rate to discount both development cost which is already inflation adjusted and cash inflows.Hope you understood my queries.ThanksThis is not actually a terribly good question – part (b) was ‘invented’ by BPP, it was not in the original exam question.
It is an option to expand.
Whatever happens they will have to pay the development costs (so the PV of those is calculated). The option is as to whether to then invest more, and the value of that is from the formula. They have then added them together although obviously the development costs have a negative PV.
With regard to the future flows, although you could inflate for 12 years and discount at the nominal rate, it would – as you say – take too long, which is why they have used the real rate.
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