Real option - lecture example

The lecture is correct. When this was set (by the previous examiner) he did in his answer what you want to do (and that is probably where your book got it from). However he was wrong and the current examiner has accepted this and amended the answer. If you look at the two terms in the formula (the Pa term and the Pe term), then if the option was exercisable immediately then the total NPV would be Pa - Pe. The extra bits in the formula (N(d1) etc. account for fact that it is exercisable in the future and give the total NPV with the option.

Hi John, Thank you. For this case I can understand to some extend that the Pa - Pe is actually representing NPV, because this is the option to delay However, how about other cases where we have option to sell project, or option to invest further,... In such case, we have additional cash flow in the future that give us the real option value, but the original project NPV is still available. Do we add the real option value to the current original NPV to get total value or not? Below is the technical article link where I see that for Option to delay, the real option value was not added to NPV but for all other cases, the option value was added. https://www.accaglobal.com/sg/en/student/exam-support-resources/professional-exams-study-resources/p4/technical-articles/investment-appraisal.html Thank you

Yes - in other cases you would add the option value to the NPV :-)