Question

When would a real option to invest in a project be out-of-the-money? Explain whether you should discard the project in that case.

Answer 1

Hello buddy,

So an in the money option is one where the price of the underlying stock has surpassed the strike price of the option and on the other hand an out of the money option is where the strike price of the option is higher than the current market price of the underlying stock or asset.

Applying the above rationale to capital budgeting decisions to be taken by the management, an in the money option would be one where the NPV turns out to be positive, i.e. the present value of all future cash flows exceeds the initial investment outlay. And on the other hand an out of the money option is one where the NPV is negative, i.e the management will not be able to recover its initial investment (in terms of options, market value of asset won't be able to cross the strike price).

Yes, since the initial outlay of funds or the investment being made is not being able to be recovered, the management should scrap such a decision and look for investment plans where it will be able to obtain a positive NPV (or an in the money real option).

I hope the above solution is what you were looking for. For any further queries or doubts in the solution, please feel free to drop a comment. Please do leave a positive feedback, Thank you :)