Caspian… at this point we must then simply agree to disagree. Frankly, I feel your response includes the details needed to answer. But lets not argue, lets start with what we agree on. 1. We are examining a project to manufacture and market a new camera. 2. Analysis of the projected CF’s results in a positive NPV. 3. A sunk cost of $500,000 was made to develop a prototype. 4. Mgmt was delaying the project to analyze the market’s response to the prototype. What would you add to or alter on that “EXPLICIT” list?
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"Must be 2 different versions of the question then. The way mine was worded it was an option. " Did your test have the word “option?” Did it say “the company has the option to delay the project by one year?” If it didnt say that, its not an option. The CFA is always, always clear about these things. “But lets not argue, lets start with what we agree on. 1. We are examining a project to manufacture and market a new camera. 2. Analysis of the projected CF’s results in a positive NPV. 3. A sunk cost of $500,000 was made to develop a prototype. 4. Mgmt was delaying the project to analyze the market’s response to the prototype. What would you add to or alter on that “EXPLICIT” list?” At the risk of looking like a jackass, I think that looks about right.
“The delay was definitely “unforced”. Which makes it an option. “Management is considering delaying the project…” etc.” I dont remember that, but obviously that can very well be the case.
caspian Wrote: ------------------------------------------------------- > "Must be 2 different versions of the question > then. The way mine was worded it was an option. " > > Did your test have the word “option?” Did it say > “the company has the option to delay the project > by one year?” If it didnt say that, its not an > option. The CFA is always, always clear about > these things. > > "But lets not argue, lets start with what we agree > on. I repeat: on the test I took, the question said (paraphrased) “management is considering delaying the project to get the results of the prototype test market.” CFA did not say “option” because they wanted to test if you know what a delay option is. Most of the examples focused on options to quit the project midway through. The word ‘considering’ was in there. That means they can delay it or they can do it now. I am willing to concede that you may have had a different question. What I am not willing to concede is that I don’t recall this detail. It hung me up for a while.
Well, that mght be the case, but I dont remember the “considering” part. I could be totally wrong (and would be wrong from the start), but I remember them having to delay the project for whatever reason. If its considering a delay, thats a different story.
Add me to the list that remember it was “management is considering delaying the project to get the results of the prototype test market.” The project already had an NPV>0, so the delay was not worth undertaking.
^^Agree. If 1-4 were present, then I think I am reasonably convinced given the definition and approaches to real option analysis cited above taken from CFAI volume III. With regards to the omission of the word option… I would say that IMO questions drafted by the CFAI have a trend of addressing straightforward concepts, yet without screaming the obvious. Including the phrase ‘option to delay’ would have been out of character. With regards to the use of the word considering… I am not convinced that is essential. Whether you are ‘considering a project delay’ or ‘delaying the project to analyze the market’s response to a prototype’ both imply a timing option is present.
This discussion is going nowhere coz no one is sure about anything. Everyone seems to remember something different. If I say this, most people think I am kidding. I may be wrong, but I remember the 500k is not sunk cost as the management is considering spending that money for the prototype. The reason I say this is that I drew a time ling for the CF, and I read the 500k part a few times to make sure it is not sunk costs and I put the number on my time line at 0, that is how I remembered it is additional investment for the project. Only one person on the forum agrees with me…you all think I am out of my mind on this… We will never know these things as they won’t release the question.
I remember just being…“The firm is going to delay the project a year” Not considering, contemplating, etc. Maybe, I read through that thing pretty damn fast. F It.
“With regards to the use of the word considering… I am not convinced that is essential. Whether you are ‘considering a project delay’ or ‘delaying the project to analyze the market’s response to a prototype’ both imply a timing option is present.” If thats the case, then its no/no and 3/4 of this thread is going to be pissed.
Does it matter actually whether an option is present? As the question asked whether the delay can impact Cap. budgeting analysis, I don’t think so analysis should change whatever be the case as NPV > 0.
My conclusion is that there are several versions of this question floating around. The institute made it that way to thwart us from putting the questions together. I think you guys nailed the concept, so depending on the way they worded the question, probably most of AF got it right.
Yeah, this is all very confusing. I had a question very similar to this one in a Stalla exam a couple days before the exam and got it wrong. So, when I this question, it really stood out to me. There are plenty of bright people on AF, so I guess the only conclusion is that there were multiple versions of this question out there.
Now, here is more fun…one AFer can’t post at work and here is what he wrote in email…he is the only one which agree with my choice:-)…I would suggest everyone to put down what they think the ORIGINAL question is for 5050 which is for North America. ******************************************************* I saw lots of posting on the NPV prototype and delay project debate. Somehow i cannot get on AF to post. So i’d like to share my 2 cents w you and you are more than welcome to paste it to the forum. i think “over50” is the ONLY person who has a same opinion as me but different from almost everyone else. So here is what i think. i I thought the problem was pretty clear and no ambiguity. It is a typical example covered by all Corp Finance text book back in school. my answer to the exam question is YES to option and YES to prototype cost. The case here is: The management of the company now evaluates the project, which by investing in a prototype, can allow them additional information 1 year down the road based on product acceptance. Say there is 60% chance the project will be successful and 40% not so successful. In case it is successful, the project has NPV of $xxx, otherwise, it has NPV of $xx (a smaller positive number or even a negative number.) However for the management to have that visibility and additional information, they have to invest $yyy on prototype at yr 0. Now, the exam question asked us, when you evaluate this project NOW, do you have to consider: 1. option to investigate and then decide based on prototype outcome 2. the prototype cost. I am very convinced the answer will be YES and YES. I hope up to this point, you all agree with me. the reason is simple: now the NPV will be: yr0 yr1 yr2… -$yyy 0.6*$xxx+0.4*$xx = Z so, the total project NPV now will be = -$yyy + NPV(Z) = W therefore the management will evaluate this project and make decision based on the value of W, (which can be +ve or -ve). i don’t see why people get so hung up on the option cost and sunk cost issue. To me that is not even the point. ONLY when you try to evaluate ONE YEAR later with the outcome of the prototype, you don’t have to consider the cost of the prototype since it is sunk. At the end of year 1, you simply make decision based on the value of EITHER $xxx OR $xx since the outcome is known by then and no more option involved!!. BUT I am sure that is NOT what the exam question was asking. The exam question itself is all about the trial with prototype. They asked if we evaluate NOW, what should we do. any comments are welcomed. I wish all of us the best luck to pass! Cheers, *******************************************************
The question was very clearly involving a prototype expense that had been paid last year making it a sunk cost that needs to be ignored. No doubt in my mind whatsoever on this one. Good luck debating it though 
I think I am probably wrong, however the only argument I have regarding the sunk cost is pretty simple and it is the criterion used to judge whether it is sunk cost of not: It is a cost that has already occurred, regardless of whether the decision to accept a project will be made. In the question, I think 1) it mentions that the start of the project depends on the results of the prototype, meaning if the prototype fails, the project will NOT start. 2) it says they plan to invest such amount to build the prototype. Even if the 2) here is not the case (the cost is already incurred), but if the decision of starting the project Based on this, I think this prototype cost is not sunk cost. Other costs such as
I think I am probably wrong, however the only argument I have regarding the sunk cost is pretty simple and it is the criterion used to judge whether it is sunk cost of not: Sunk cost is a cost that has already occurred, REGARDLESS of whether the decision to accept a project will be made. In the question, I think 1) it mentions that the start of the project depends on the results of the prototype, meaning if the prototype fails, the project will NOT start. If you don’t start the project, you don’t even have a NPV. 2) it says they plan to invest such amount to build the prototype. Even if the 2) here is not the case (the cost is already incurred), but if the decision of starting the project hinges on the prototype result, it is not sunk cost.
Yes it is. They’ve already spent the cash to develop the prototype. To figure out if it is a sunk cost ask the question: can they get it back? No. No matter what they do with the project, they have already spent money on the prototype. I can’t believe we are arguing about this…
Definitely was a sunk cost…I read the vignette BEFORE reading any of the questions and when I got to that section I wrote “sunk cost” in the margin.