Question

Should the company exercise investment timing option and wait a year before proceeding? Prove.

Answer 1

An “investment-timing option,” one form of real option to defer the investment for at least one year (T=1). Delaying investment in a project, say for a year or so, may allow a firm to evaluate additional information regarding demand for outputs and costs of inputs.This option can be seen as strategic change  in a project during its lifetime. An example is, mining firm's option to delay the extraction of natural resources if the price falls below the extraction costs, with an assumption that after 1 year they can coverup the loss occured today, due to the timing option. Such strategic options are known as real options (timing option, to be precise), and, can significantly increase the value of a project by eliminating unfavorable outcomes.Investing in a project today or waiting one year to invest in the same project is an example of two mutually exclusive projects.

At T = 0, management estimates that the new mining export bill has a 40% chance of being passed. At T =1, it will be known for certainty whether the new bill has passed. The benefit of deferring the investment decision for one year is that the company can avoid the less profitable (or money-losing) choice. The drawback of the delay decision is that the expected future after-tax cash flows are deferred. The trade-off of these two effects tells us whether the company should defer the investment to T=1 or not.

This decision of investing now or later, mathematically, depends on the expected NPV of the delayed investment. It makes sense to defer the investment only when two conditions are satisfied: (1) the expected NPV of the delayed investment is positive, and (2) this NPV is higher than the expected NPV without deferral.

An investment opportunity with positive NPV does not mean that we should go ahead today. In particular if we can delay the investment decision we have an option to wait. The optimal timing is a trade-off between cash flows today and cash flows in the future. Following three steps should be followed for making a timing option decision:

First, Find the expected NPV for the project as if one particular option were taken. For example, we can calculate a separate NPV for deferring and another NPV for not deferring the investment.

Secondly, Make the decision based on the new information to be revealed at a specified future point in time.

Thirdly, Compare these expected NPVs. Subtract the value of the project without option from the value of the project with option to determine the value of the real option. This value indicates the optimal decision.