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Sir i have confusion regarding this question, for option to delay its a call option and that the exercise price is normally the capital investment so,
1. The 14 million for the first 2 initial years i feel should be sunk cost as its development related costs, but examiner has taken it and increased the span of project to 6 yrs
2. Even if the 14 million is capital expenditure, then why has examiner taken 35 million only as exercise price shouldnt it be 49million??
1. It is not a sunk cost because whether or not we buy the option, if they do go ahead these costs will still have to be spent. If we do not go ahead then these costs will not be incurred.
2. The exercise price is 35M because the question says so – it they do decide to continue after the first 2 years then they will have to pay out 35M.
Hi John,
Could you please explain why we don’t discount the 35 million? If the cost is incurred in 2 years time should it not be discounted by 1/1.11^2 (cost of capital)?
Thanks!
It has been discounted!
The second part of the Black Scholes formula (the part that multiplies Pe) is doing the discounting on a continous bases and we don’t need to discount twice 🙂
Sir as per my understanding the initial investment of 12m should be taken as initial expenditure before taking account of option to delay getting the resultant npv of 35.75m ie (47.75m_12m) initial investment _ PV of returns but the answer has taken 35m as initial expenditure before taking the option and also after taking the option to delay
No – they will spend 7M per year whatever happens.
The option is as to whether to spend $35M in two years time in order to then earn money from the game for the following 4 years.
I find this prolem wording confusing. if MMC does not take the 7M expenditure per year in the first 2 years, then the company cannot produce and distribute the product, then the option to delay for two years is compulsory rather then optional, but why the problem still ask to evaluate the financial impact of directors’ decision to delay the production ?
And why the answer is 9.53-2.98 =6.55 ? as I think the initial NPV to input to BSOP should be NPV without exercising the option and in this case it is not -2.98, but i think the cost 35m should be spent in year 0, therefore, with cost of capital 11%, the discount rate will be 1, and cash flows of 25,28,10,5 should be respectively in year 1,2,3,4, and then the discount rate must be 0.901;0.812;0.731 and 0.659 to arrive at the intial NPV before taking as input to BSOP.
Thank you!
I hope i do not encounter a problem with that confusing wording like this!The option is to delay the decision as to whether or not to produce and market the game for two years.
It is not to delay the development of the game – they will develop it regardless. With the option they will then be able to decide after two years whether or not to carry on and produce and market it.
but as they spend two year to develop the game, how they can consider to produce, distribute and market the game RIGHT NOW, if they donot delay the option for TWO YEARS? The delay is compulsory but not optional.This is what I do not understand about this problem?
Moreover, I want to ask why Total value of project = NPV without option to delay+ The call option value of the option to delay? (that is 9.53m-2.98m=6.55m)
Again, what is being delayed is the decision as to whether or not to spend another 35M in two years time in order to produce and market the game.
If the option does not exist then either they do nothing or they spend 7M a year for 2 years and then spend another 35M. On the currently projected cash flows, this would result in a negative NPV and therefore they would do nothing.
With the option, they can spend 7M a year for 2 years developing the project and then see what the likely further receipts will be (they might be higher or lower than the current estimates because of the volatility) – they have the option in 2 years time whether or not to continue with production and marketing.
Having that option is beneficial (if in 2 years time the prospects look good then they will continue, if in 2 years time the prospects look bad that they will not continue). Therefore the NPV of the whole project is higher by the value of the option.
Additionally, I want to ask why Total value of project = NPV without option to delay+ The call option value of the option to delay? (that is 9.53m-2.98m=6.55m)
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