I’m squarely with bannisja here… I mean, this says it all: “Delaying an investment and basing the decision on the BETTER information gained by waiting may improve the NPV of the overall project.” So, if there is a timing option that incorporates waiting, you should consider it when assessing the validity of the project… +1 for me and Banni
I am breaking my promise I know, sorry. I just read some qbank q’s on types of real options and I felt obligated to post the additional info. Q1.) project + “decision to wait” ~ “consider a delay” = a project that includes a timing option. Q2.) independent project + positive npv + real option… no need to adjust NPV for real option. “The value of a real option is always positive. For an independent project, if the project is already profitable, a manager can accept the project simply knowing that the real option will simply add to the profitability” It has nothing to do with discounting for the delay, and nothing to do with gaining better info. It is a timing option, it is a type of real option, it has a positive value. If it is an independent project, (and it was), if the NPV is +, (and it was), then no adjustment to NPV is needed, you can accept without determining the option’s value. I know it’s a dead horse and I’m not here to personally take anyone’s points away, I’m just sayin.
If you take out the gain on sale in the last year, it’s still a positive NPV project. Does that mean you shouldn’t include it in your analysis?
There is no OPTION to delay the project. The vignette clearly states that project has been delayed because there was some sort of hold up. Absolutely no option whatsoever. A delay needs to be factored into the NPV calculation.
I put recalculate on the exam, but it clearly seems that was the wrong answer. The fact that management CAN delay the project means there is a timing option.
I can’t speak to what the vig stated. If someone said ‘considering’ delay to examine something regarding the prototype I wouldn’t remember which. Either way, the project included a timing option. Really, this setup could not fit the real option concept mold any better. But don’t take my word for it. CFAI Volume 3 pg. 56: “Timing Options: Instead of investing now, the company can delay investing. Delaying an investment and basing the decision on hopefully improved information that you might have in, say, a year could help improve the NPV of the projects selected…” “There are several approaches to evaluating capital budgeting projects with real options. One of the difficulties with real options is that the analysis can be very complicated. Although some of the problems are simple and can be readily solved, many of them are so complex that they are expensive to evaluate or you may not have much confidence in the analysis. Four common sense approaches to real options analysis are presented below. 1. Use DCF analysis without considering options. If the NPV is positive without considering real options, and the project has real options that would simply add more value, it is unnecessary to evaluate the options. Just go ahead and make the investment.” Sound familiar? delay an investment, say one year, unnecessary to evaluate, just go ahead? Sorry, I’m not trying to be a smartass. But SFMatt going sarcastic and people dropping caplock on me makes me pull out the bible.
i think some people have mis-read the exam question… guys are probly thinking a practice question they have done… that a project has a positive NPV but also a real option that has positive value - but not sure how much yet, should the manager go ahead with the project or wait until find out the value of the real option. The answer is no coz regardless the value, the value of NPV > 0, therefore go ahead. - but this is a different concept the exam is asking for. I am pretty sure delaying the project will impact the NPV.
I remember this question. All i can say is that i said no / yes. I seriously do not believe it was in regards to a real option. Prior to go into the exam i had my real options down, and from what i gathered from the question, it was not referring to a real option. Just my two cents.
It is very clear what a timing option is… per the quote below: “Timing Options: Instead of investing now, the company CAN delay investing. Delaying an investment and basing the decision on hopefully improved information that you might have in, say, a year could help improve the NPV of the projects selected…” The key word here is “CAN”. If the project was going to be delayed regardless of what they want, they do not have an OPTION to delay the project, and there is no option. For example: If you are building a 20 story building and the project is delayed because your crane colapsed, you do not have a timing option… the project is just delayed. The fact that there is an unwanted delay pushes back the cashflows one year into the future and the NPV of the project is reduced. Therefore, whether or not there is an option involved is entirely dependent upon the specific circumstances in the vignette.
Thank you McLeod. That is exaclty what I am trying to describe. What you lay out is a straightforward concept. Cash outflow, then a delay in realizing the cash inflows results in a lower project NPV. If that’s what we have then No-Yes and -1 over here. But here is the difference. No initial investment has been made. You are not building a building and the crane collapsed. You are deciding if you want to build that building and delay the decision to accept the project pending further information. What we have here is: sunk cost, prototype, delay acceptance to research response to the prototype, then decide accept or not. That is a timing option. If that’s what we have then No-No.
McLeod81 Wrote: ------------------------------------------------------- > It is very clear what a timing option is… per > the quote below: > > “Timing Options: Instead of investing now, the > company CAN delay investing. Delaying an > investment and basing the decision on hopefully > improved information that you might have in, say, > a year could help improve the NPV of the projects > selected…” NPV of the project was already positive, so you might as well go ahead with the investment rather than wait for the information. > > The fact that there is an unwanted delay pushes > back the cashflows one year into the future and > the NPV of the project is reduced. Therefore, > whether or not there is an option involved is > entirely dependent upon the specific circumstances > in the vignette. You are right NPV of the project is reduced (because its discounted for 1 more year) but what ever be the case it will still be positive. So you can go ahead with the investment.
kabhii Wrote: ------------------------------------------------------- > You are right NPV of the project is reduced > (because its discounted for 1 more year) but what > ever be the case it will still be positive. So you > can go ahead with the investment. How how do assume that the NPV will still be positive without recalculating the NPV under the new assumptions (that is, the assumptions that all cash flows are delayed by one year). Again, there is no option because the delay is a forgone conclusion and not something that is subject to management discretion. What you have to adjust the NPV for is the fact that an unforseen event has delayed the project. There is no option left. Even if there was an option at one point, it has been exercised and therefore has no remaining value. The intrinsic and time value that existed while the option was outstanding is GONE, and all that would be left is the certainty that the CF’s will be extended 1 year into the future, which may or may not reduce the NPV below zero depending upon the discount rate. NPV total = NPV project + Value of Option When the option is outstanding, the NPV total will always > NPV project because the option has positive value (and project NPV cash flow / discount rate assumptions are constant). If a timing option has already been exercised, “Value of Option” = 0 and, in this case, NPV project is lower because of a change in the project’s cash flow assumptions. If the NPV drops by an amount greater than the original NPV total, than NPV < 0. There is no way to know how much the NPV will fall from what we are given in the vignette. What we do know, is that we need to recalculate the NPV to make sure that it is greater than zero…
the question was: should the analyst change his cap budget analysis and not if the investment decision could change… dont think it was an option question -surely change the analysis to calculate the new NPV.
McLeod81 Wrote: ------------------------------------------------------- > kabhii Wrote: > -------------------------------------------------- > ----- > > > You are right NPV of the project is reduced > > (because its discounted for 1 more year) but > what > > ever be the case it will still be positive. So > you > > can go ahead with the investment. > > > How how do assume that the NPV will still be > positive without recalculating the NPV under the > new assumptions (that is, the assumptions that all > cash flows are delayed by one year). Consider this year as 0 and as per the exam question we assume NPV > 0 Now, If all the cash flows are delayed by one year, that is your intiial outlay, yearly cash flows and terminal cash flows then in that case this NPV amount will be realised in year 1. So if we discount that amount to year 0 it will be positive. > NPV total = NPV project + Value of Option > > When the option is outstanding, the NPV total will > always > NPV project because the option has > positive value (and project NPV cash flow / > discount rate assumptions are constant). In the exam question, NPV project was greater than 0, so if value of option is always positive so we don’t need to change our capital budgeting analysis to reflect that option. We can straight away take the project. > > If a timing option has already been exercised, > “Value of Option” = 0 and, in this case, NPV > project is lower because of a change in the > project’s cash flow assumptions. Ok, since you already said that option has a positive value and it will always increase the NPV of project. What this means is that after the option exercise whatever changes took place in cash flow assumption it won’t decrease the NPV. Why? because you won’t exercise the option if the NPV is supposed to go down after the exercise.
McLeod81 Wrote: > How how do assume that the NPV will still be > positive without recalculating the NPV under the > new assumptions (that is, the assumptions that all > cash flows are delayed by one year). Again, there > is no option because the delay is a forgone > conclusion and not something that is subject to > management discretion. What you have to adjust > the NPV for is the fact that an unforseen event > has delayed the project. There is no option left. We don’t assume. We valued the project based on the projected outlay and projected cash flows. Following a delay we will value the project again, this time using any new information to refine our projections. At that time we then have the option to accept or decline. What you are describing is quite different really. You already started your project and found that your projected cash flows are delayed. Here, I am delaying the decision on my project, (forced or unforced is irrelevant, and frankly I don’t recall it described as forced). Following this delay I will then decide if I want to accept or decline. You can’t do that with your project since you already accepted, made the initial outlay and therefore do not have a project timing option. I do. I made no initial outlay.
slouiscar Wrote: ------------------------------------------------------- > Here, I am delaying the decision on my project, > (forced or unforced is irrelevant, and frankly I > don’t recall it described as forced). Following > this delay I will then decide if I want to accept > or decline. The delay was definitely “unforced”. Which makes it an option. “Management is considering delaying the project…” etc.
oh no! Another mistake. Well, before today I was convinced of failing anyway…
“There is no OPTION to delay the project. The vignette clearly states that project has been delayed because there was some sort of hold up. Absolutely no option whatsoever. A delay needs to be factored into the NPV calculation.” I cannot believe this is still being debated and I cannot believe people are arguing about what the question said. The question was EXPLICIT in that it said the project was being delayed. It made NO mention of an option to delay it, it may no mention of anything other than the fact that the company could not begin receiving the cash flows for a year. This is NOT a real option, it is a delay in receiving cash flows which reduces NPV. The question was EXPLICIT.
caspian Wrote: ------------------------------------------------------- > “There is no OPTION to delay the project. The > vignette clearly states that project has been > delayed because there was some sort of hold up. > Absolutely no option whatsoever. A delay needs to > be factored into the NPV calculation.” > > I cannot believe this is still being debated and I > cannot believe people are arguing about what the > question said. The question was EXPLICIT in that > it said the project was being delayed. It made NO > mention of an option to delay it, it may no > mention of anything other than the fact that the > company could not begin receiving the cash flows > for a year. This is NOT a real option, it is a > delay in receiving cash flows which reduces NPV. > The question was EXPLICIT. Must be 2 different versions of the question then. The way mine was worded it was an option. I mean, there ARE several questions CFAI altered across different regions. Doesn’t surprise me.
think people were still arguing it because noone really could recall the specifics of the question. you cleared that up.