Saturday, December 18, 2010


Timing Option in Investment Appraisal

Suppose there is no abandonment option. Should the company reject the project as it has a negative net present value (NPV)? If the company management consider the project as a one time “now or never” opportunity, it will be tempted to reject the project. In fact, the company has the option to wait and see how economic conditions turn out to be in the future. If the economic conditions become favorable in the future, the company can undertake the project. The firms create a call option through its approach of wait and see. Deferring an investment helps the firm to receive useful information about the economic and riskiness of the project. With this information, the firm will be in a much better position to decide about the investment project. The timing options (or options to delay) are highly valuable, particularly those firms that operate in highly dynamic economic and competitive environment.


Suppose The Center for Advanced Professional Studies (CAPS) institute is considering installing a solar system for heating water in hotels for students. The system will cost 25 million $ and it is expected to save electricity expenses at the current electricity rates by 2.1 million $ forever. At a cost of capital of 10%, the value of saving is 2.1/0.1 = 21 million $ and the net present value is 21-25 = -6 million $. Since net present value is negative, the project is unattractive for CAPS. Suppose the electricity rates will fluctuate and the saving may be either 1.2 million $ or 3.50 million $. If the saving are 1.2 million $, then the net present value is 1.2/0.1-25 = -13 million $. The project is unprofitable. On the other hand, if saving turn out to be 3.5 million $, then the net present value is: 3.5/0.1-25 = 10 million $. The project looks very attractive now. What should CAPS management do? Should it reject the project or should it wait and see how the electricity rates change? You may recognize that delaying the investment gives CAPS management a chance to see how the electricity rates behave. If the electricity rates increase, CAPS’s saving will be very high. Delaying the project is like as American option. What is value of this option to CAPS?

Valuing option to delay

In case of a stock option, we must note that a dividend payment before the call option matures reduces the ex-dividend price of the stock and the call option’s payoff at maturity. In then case of a non-dividend paying American call option, it should not be exercised before maturity since it is always more valuable until the maturity. This is not necessarily true is case of dividend paying stock. If dividends payments are vary large, it may be more advantages to the call option holder to exercise the option just before the ex-dividend date. An investment project’s cash flows have the same effect as the payment of dividends on the value of a stock option. The Black-Scholes method, adjusted for the payment of dividends, to value an American call option, but it will not give value of call option exactly. The Binomial method values the American call option more accurately.