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Lecture 28

FINA 410 Lecture 28: CHAPTER 28 – THE OPTION TO DELAY AND VALUATION IMPLICATIONS
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Department
Finance
Course Code
FINA 410
Professor
Jean Mayer

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find more resources at oneclass.com CHAPTER 28 – THE OPTION TO DELAY AND VALUATION IMPLICATIONS  In traditional investment analysis, the decision to accept a project only when return on project > hurdle rate  + NPV proje▯ts ▯ased o▯ CF’s a▯d dis▯ou▯t rates  Limitation of this view is that it does not consider the options associated with many investments.  One of the limitations of traditional investment analysis is that it is static and does not do a good job of capturing the options embedded in an investment: o the option to delay it o The other opportunities in the future that may be available just because we took the investment o the option to abandon it, if the cash flows do not measure up.  These optio▯s all add ▯alue to proje▯ts a▯d ▯a▯ ▯ake a ▯▯ad▯ i▯▯est▯e▯t (from traditional analysis) into a good one.  This chapter considers the option to wait and take the project in a later period  Why would a firm want to do this? o If the PV of CF’s are ▯olatile a▯d ▯a▯ ▯ha▯ge o▯er ti▯e, a proje▯t that does ▯ot pass now (-NPV), may become valuable in the future o Maybe the project has a +NPV, but the firm may gain from waiting because the project has a higher value if taken at a later date  Most valuable when a company has exclusive right to invest in a project and becomes less valuable as the barriers to entry decline.  Three cases where the option to delay can make a difference when valuing a firm: o 1) undeveloped land in the hands of real estate investor or company  The choice of when to develop depends on owner, and will usually begin to develop when real estate value increases enough to justify it o 2) a firm that owns a patent  since patent represents a firm with exclusive right to produce a product or service  it should be valued as an option  so we produce the patented product? o 3) a natural resource company that has undeveloped reserves that it can choose to develop at a time of its choosing—presumably when the price of the resource is high THE OPTION TO DELAY A PROJECT  Usuall▯ ▯e look at CF’s a▯d dis▯ou▯t rates a▯d ▯o▯pute the NPV to see if acceptable  Ho▯e▯er, CF’s a▯d rates ▯ha▯ge o▯er ti▯e  changing NPV  so a project that has – NPV today (rejected) may have a +NPV (accepted) in the future o For regular fir▯s, the fa▯t that it ▯▯a▯ ▯e▯o▯e positi▯e i▯ the future▯ does▯’t matter as they do not have a special advantage over their competitors (their competitors will have a +NPV too)  In an environment where project can solely be taken by one firm, due to legal restrictions or other barriers to entry  the changes in the projects value over time are find more resources at oneclass.com find more resources at oneclass.com relevant and gives it the characteristics of a call option (right to buy)  value = (V-X) where X is initial upfront investment, and V is the PV of cash flows to the project Payoff on the Option to Delay  NPV projectV – X o X: initial up-front investment o V= PV of expected cash inflows from investing in project  Now assuming the firm has exclusive rights  if discount rate or cash flows changes  the PV of CF’s ▯V) may change over time while the initial up-front investment (X) stays the same o So even if currently it has a –NPV, it may still be a good project if the firm waits.  Decision rule: o If V>X  Invest in project as it has +NPV o If V
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