Real Options - Capital Budgeting

From the 2020 CFAI curriculum, volume 3, page 54 the example for the Abandonment Option.

So I understand real options, and determining NPV without the option then calculating if the real option is valuable enough to overcome a negative NPV, but the final answer in this example confuses me.

From page 53, the project NPV = NPV (only using DCF) - Cost of the Option + the Value of the option.

The example on page 54 indicates the project NPV is -9.808, therefore unviable without the option.

We calculate the probabilty weighted value of the option next and determine it is +13,158. So certainly the project is viable given the value of the real option. I seem to understand things up to that point…

…then, the example says the real option raises the NPV by 22,966. It does so by 13,158 - (-9,808). I’m completely confused why we calculate the increase in the NPV of the project as being 22.9k. Logically, I can’t wrap my head around how the additional value of 13k moves the NPV that much.

I can see the math but can’t understand why we are subtracting the -9.8k.

Thanks.

The value of the option is just 22.966, that is, it raises the NPV from -9.808 to +13.158.

Best, Oscar

Thanks Oscar - I know I’m having a real “i just don’t get it” moment, but I think I got it.

I was confusing the NPV of the 2 weighted options as being only for the abandonment options when in fact it was for the ENTIRE project including the abandonment options.

So, without the options we have a project with negative NPV. But, when we calculated the NPV of the entire project and include the 50/50 probability of the cash flows associated to the 2 abandonment options, we end up with a project that has an NPV of 13,158. Therefore those options swing the value of the project from -9,808 to 13,158. Hence the 22,968 value.

Thanks.

The expected NPV for the projectoption to not abandon or abandon the project is (.5)(53,589) + (.5)(-27273) respectively is 13,158. Is the expected NPV from these probability weighted options not considered the value of the abandonment option?

The non-option value of the project is