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Dear tutor!
In BPP revision kit question 26 Digunder (12/07) it is asked to estimate the value of the option to delay. I thought that present value of project should be calculated like this: 24/(1.1)^2+4=23.83mln
In answer there is following calculation of present value of project = 24 mln (investments in 2 yrs)+4 mln (NPV)=28 mln. But I can’t understand why we shouldn’t discount investments which will take place in 2 yrsThe BPP answer is correct.
If they were to do the project today, the would pay out 24M today and get an NPV of 4M today, so the PV of the returns is 28M.
The fact that they have the option to wait 2 years before deciding whether to invest the same amount in the same project is what makes the option valuable.
The Black Scholes formula does effectively discount (the part of the formula with ‘e’ is it is actually doing the discounting).
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