ACCA AFM Syllabus B. Advanced Investment Appraisal - Option to delay or defer - Notes ^{5 / 7}

The key here is to be able to delay investment without losing the opportunity, creating a call option on the future investment.

Illustration

MMC is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 24 months. 

However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful. 

MMC has forecast the following PV of cash flows:

The company will require $35 million for production, distribution and marketing costs at the start.

The relevant cost of capital for this project is 11% and the risk free rate is 3•5%.

MMC has estimated the likely volatility of the cash flows at a standard deviation of 30%.

Required:

Estimate the financial impact of the directors’ decision to delay the production and marketing of the game.

Solution

1. Calculate NPV

   Net Present Value = $(2•98 million) 

   On this basis the project would be rejected.

2. Present value of project’s positive cash flows discounted to current day:

   $18•28m + $11•86m + $5•93m + $2•68m = $38•75m

3. Identify variables: (which are then placed into the BSOP calculator)

   Current price (Pa) = $38•75m
   Exercise price (Pe) = $35m
   Exercise date = 2 years
   Risk free rate = 3•5% (show this as a decimal in the calculator)
   Volatility = 30%(show this as a decimal in the calculator)

As the option to defer is a Call option - the result you need is variable C

So, the overall value of the project = $9•53m – $2•98m = $6•55m

Since the project yields a positive net present value it would be accepted.