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Hi,
I’m confused by two examples of real option valuation related to a “delay” option.
In the ACCA technical article, one example is about delaying the decision making on investing in a project by two years, i.e., all the cash outlays and inflows are also delayed by two years. And the value of the option calculated using the BSOP model represents “the project value with the option to delay”.
While in Q17 of BPP revision kit, there’s also an option of delay in decision making, but this time the value of the call option represents solely “the value of the option to delay”, and project value with the option to delay is the NPV of the project without the option of delay plus the value of the call option.
I wonder why in the first example the call option value represents the “project value with the option”, but in the second example, the call option value only represents the value of the option to delay? Is there a difference between option to delay a project (Cash flows also delayed) and option to delay decision making (cash flow not delayed but decision delayed)
Thank you very much!
The technical article is correct and the BPP answer should not have added the two together.
The confusion arose because the first time valuing this kind of option was asked in the exam, the examiner’s answer was wrong (and the examiner afterwards accepted this). It seems that BPP has not updated their answer for the error 🙁
Hi John,
Thank you very much for your clarification.
I’m trying to figure out a correct answer to this question: it seems that the option in question is: if project value in the future exceeds $35m, then exercise the option and go for the additional investment of $35m, if project value falls below $35m, and do not invest further. It seems that the two $7m initial investments were not considered in the option at all, and they would have been incurred no matter what.
So can we consider the $7m investments separately to the $35m further investment and future cash inflows?
If we completely ignore the two $7m investments:
The option value is still unchanged at $9.127m, however, the NPV of the project is -$28.42+$18.28+$11.86+$5.93+$2.68=$10.33m. It looks like the project value with option is lower than the project value without option to delay-this gives a negative value added by the option of delay, but in theory an option couldn’t lower value of a project…
I’m confused by the calculation results… Could you please help to see what’s wrong here? Thank you very much!
Sorry, I should have explained this as well (the whole question was too ‘clever’ which is what made it all a bit ridiculous and therefore would not be repeated in this form).
What makes it different from the example in the technical article is that as you say, the 7M a year will be paid whether or not they have the option.
If we ignore the 7M’s then without the option the PV now of the flows from 2 years onwards is $10.33M.
With the option (still ignoring the 7M’s), then in the formula they should have used Pa as being 28.42M and not as 35M. (I know that seems inconsistent with the article, but it is because it is not the payment itself that is being delayed but the decision as to whether or not to make the payment.) If you do that, then whether or not we include the 7M’s in both calculations it does make the project with the option better than without the option 🙂I am sorry for not explaining this before, but again the examiner himself admitted that it did turn out to be a ridiculous question which is why the technical article appeared later.
Hi John,
Thank you very much for your detailed explanation. Everything suddenly makes sense 🙂
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