I have seen this discussed briefly in the Corp. Fin thread and it seemed there was some debate. I wanted to pull it out to seek clarification. If you have a project w/ a positive NPV, 1. you certainly do not adjust the NPV for a sunk cost, such as say, the development of a prototype. (No NPV adjustment) 2. if you are considering the possibility of delaying the project, you do not adjust the NPV because the decision to delay is an option that has value. since the original project has a +NPV the addition of this option would only add value and not cause you to reject. (No NPV adjustment)
I failed.
so it means right answer is REAL OPTION, right?
So the answer was n/n?
I understand the whole positive NPV thing and why it wouldn’t matter, but who’s to say that in a year, you will still have a positive NPV? A year from now, a lot of things could change (cost of equity, debt, tax’s). How could you just ignore the year delay? Let’s go to the extreme, what about 100 years from now instead on one. It just doesn’t make logical sense to me.
slouis, you may be right, but I remember the delay as more of a restriction than an option. It said something to the affect that company may have to delay the project for some reason, I think. Regardless, I’m with mwvt9 on this one.
mwvt9 Wrote: ------------------------------------------------------- > I failed. I am far from confident in the explanation I gave for #2. It is definitely not related to how well you did on the overall exam.
i forget the exact wording of the question, but: i went No on the sunk cost and yes on the option because it has value…
“2. if you are considering the possibility of delaying the project, you do not adjust the NPV because the decision to delay is an option that has value. since the original project has a +NPV the addition of this option would only add value and not cause you to reject. (No NPV adjustment)” This was not an option to delay realizing the cash flows. It was a delay in the project which negatively impacts the NPV. So you have to push the cash flows out one year. The question said nothing about the option to do so.
Let’s put this to rest once and for all. For the record, I missed it too. Per Schweser, the principals of capital bugeting: “The timing of cash flows is important: Capital budgeting decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be recieved later.” And more Schweser on options: “Real options allow managers to make future decisions that change the value of capital budgeting decisions made today.” “Timing options allow management to delay making an investment with the hope of having better information in the future.” “A manager can us a number of different approaches for evaluating the profitability of an investment with real options.” I’m afraid there can be no doubt that this question was referring to this third point.
mark / clipper I had no idea this was a real option until reading a post after the fact. My reasoning for choosing no was as follows: Since the project cost and revenue expectations do not change, the NPV at acceptance would be the same whether you accepted this project today or tomorrow. If you delay, by choice or restriction, you make no investment now, then after one year, or 100 years, you then make the investment and receive the CF’s resulting in the same NPV when you accept. Hence the NPV of the project is not impacted by when you actually decide to accept. umm, yeah something like that, I hope.
I hate questions like this where someone can fully understand the concept, but just are not sure what they are asking (do you want to know whether i know that the option has value or do you want to know if i understand that it doesn’t need to be included since the NPV is already positive?). Maybe the actual wording on the exam was perfectly clear and it’s wasn’t an issue for this particular question, but I do remember having this type of problem a few times.
cps44 Wrote: ------------------------------------------------------- > I hate questions like this where someone can fully > understand the concept, but just are not sure what > they are asking (do you want to know whether i > know that the option has value or do you want to > know if i understand that it doesn’t need to be > included since the NPV is already positive?). > Maybe the actual wording on the exam was perfectly > clear and it’s wasn’t an issue for this particular > question, but I do remember having this type of > problem a few times. there were many questions like that in exam
I chose “No / No” for this because I felt they were talking of Real options in the 2nd part. 1st part was obviously Sunk cost which does not need to be factored in NPV calculations. So, did I lose one more point now??
NPV for net PRESENT value…you can’t say the npv is the same in one year or 100 years…npv is the value NOW.
I think the question asked if her had to consider it, not if it would specifically change/ lower/ increase NPV. That how I answered anyway… have to consider prototype??: no bc its a sunk cost have to consider timing?: yes
caspian and over05. I initially agreed there that if the project NPV is 1500, but I delay for one year, then the project NPV is 1500/(1+r), …we just adjusted the project NPV to t=0 for the delay. But I reversed that and went no, thinking that the delay does not impact the project’s NPV. The project is still the same, t=0 outflow of -X year 1-5 +CF’s. The delay justs delays when your company accepts this +NPV project. Dwight Wrote: ------------------------------------------------------- > “Timing options allow management to delay making > an investment with the hope of having better > information in the future.” That’s it right there. Delay making an investment. NPV + timing option. **Edit: I am most likely quite wrong here and thats cool. -1 for me. I am just outlining my reasoning to see where it is flawed. Thx.
this isn’t good for my mental health. WTF IS THE ANSWER??!!
cfasf1, I’m fairly sure the answer was you don’t include the sunk cost of the prototype, but you should consider the effect of a yearlong delay.
"But I reversed that and went no, thinking that the delay does not impact the project’s NPV. The project is still the same, t=0 outflow of -X year 1-5 +CF’s. The delay justs delays when your company accepts this +NPV project. " Except you are evaluating the project NPV *today*, not in one year. If the project doesnt start for another year, then the NPV *today* is impacted. The other thread went over this quite thoroughly I believe.