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hi, John
I’ll never ever get the real option concept. let’s take Q1 from December 2013 as an example: https://opentuition.com/acca/p4/acca-p4-question-1-december-2013-part-3/
I believe we calculated that in case of continuing the project the sum of PVs of the last 3 years equals approximately $30,613,600. we also figured out that this would not bring us a positive NPV. still we are happy to take $28,000,000 instead of that sum as we calculated using BSM that in this case the project would result in positive NPV. where is the logic?
I can see how we proceed with the calculation, but my brain refuses to take this as a plausible explanation. any help?
The $30,613,600 is the PV of the flows assuming that they are certain.
The problem is that they are very uncertain and therefore the actual flows may be a lot higher or a lot lower.
By having the option they know that they cannot get less than $28M. If things are going well then they will not exercise the option and get potentially much more, but if things are going badly then they will exercise the option and be sure to get $28M.So the fact that having the option limits the worst outcome is worth having, and makes it more worthwhile overall.
Just making up some very simple figures:
Suppose the actual PV could be as high as 50M or as low as 10M (with an average of 30M). If it was 50M then overall it would be worthwhile, if 10M then not worthwhile, but the calculation has been based on the ‘average’ of 30M.
With the option, if the PV turned out to be 50M they would not exercise the option and would get 50M. If the PV turned out to be only 10M then they would exercise the option and get 28M. Having this option does make the investment more attractive (even though, as is the case in all decisions based on estimated flows, it does not guarantee that it will be certain to end up worthwhile).
Without the option they might end up doing really well or they might end up doing really badly. With the option there is still the same chance of doing really well, but doing badly is nothing like as bad as it would be without the option.aha. so, you’re saying that all this is because of volatility of the data on which we’re basing our calculations. now that we’re sure that we can only do worse than the average by about $1.4M, and considering that we can do better than the average as before, our chances and NPV are improving.
make sense to me )
thanx for your comprehensive answer!
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