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Sir my understanding is that in case of option to abandon, we use basic NPV+ Value of real option. But then don’t you think we have 2 mutually exclusive alternatives: One is to finish the project till its end of life and earn the NPV the other alternative is to dispose the project some time later. So as far as providing a conclusion is concerned, we should take NPV Vs. Value of real option, as they are mutually exclusive alternatives. But my study text takes: basic NPV for whole life of project+ Value of real option(in which we plan to dispose off the project in 2yrs). This seems so strange to me, as we don’t earn the NPV for the whole life, once we sell off the asset 2yrs later. So then why add???
i hope you understand my rather convolutedly(sorry about that) posed question.
If there were no option available, then going ahead with the investment would mean having to keep it for its entire life, even if the inflows in the future turned out to much less than were originally expected (and had they known about this from the start then maybe they would not have down the investment).
Having the option means that if the flows do turn out to be less than expected then they can abandon and not incur the later losses. This is a benefit and the option has a value.
It also makes the NPV of the project greater – the knowing that they can abandon if things turn out badly means that the project is more attractive than if they had no choice but to continue with it.
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