Q MMC June 11

If the option did not exist the the NPV would be – 2.98M and we would not go ahead with the project. I think you are happy with that.

However, the cash flows during the sales period are uncertain. So they might be lower than estimated (in which case we would be pleased not to have gone ahead), but they could be higher than expected (in which case the project may well have been worthwhile).
Again, without the option, if we did do the project we would be committed to spend the extra 35M in two years time whether or not the returns were going to be higher or lower than currently estimated.

What the option does is allow us in 2 years time to either invest the extra 35M (and then get the returns which might be a lot higher), or simply stop after 2 years and not invest the extra (and not get the returns).

Therefore having that option is worth something to us – it still gives us the chance of continuing if the returns are likely to be a lot higher than we currently expect, but allows us to pull out if they are not higher.

The BS formula puts a value on this option, and it means that with the option, the project is worth more to us that it was before (i.e. the current NPV plus the value of the option).

The $7M’s are not relevant when calculating the value of the option because they would be invested anyway whether or not we exercised. The option is as to whether to invest the extra $35M or not.

I hope that helps 🙂

You are welcome, and thank you for your comments 🙂