Option to delay or defer
The key here is to be able to delay investment without losing the opportunity, creating a call option on the future investment.
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%.
Estimate the financial impact of the directors’ decision to delay the production and marketing of the game.
Net Present Value = $(2•98 million)
On this basis the project would be rejected.
Present value of project’s positive cash flows discounted to current day:
$18•28m + $11•86m + $5•93m + $2•68m = $38•75m
Current price (Pa) = $38•75m
Exercise price (Pe) = $35m
Exercise date = 2 years
Risk free rate = 3•5%
Volatility = 30%
Calculate d1 = (ln (Pa/Pe) + r + 0.5xs^2) t) / s√t
d1 = [ln(38•75/35) + (0•035 + 0•5 x 0•30^2) x 2]/(0•30 x √2) =
d1 = (0.10178 + 0.16) / 0.42426 =
d1 = 0•6170
Calculate d2 = d1 - s√t
d2 = 0•6170 – (0•30 x √2) = 0•1927
Using the Normal Distribution Table provided
N(d1) = 0•5 + 0•2291 + 0•7 x (0•2324 – 0•2291) = 0•7314
N(d2) = 0•5 + 0•0753 + 0•3 x (0•0793 – 0•0753) = 0•5765
Value of option to delay the decision
= Pa N(d1) - Pe N(d2) e^(-rt)
= 38•75 x 0•7314 – 35 x 0•5765 x e^(–0•035 x 2)
= 28•34 – 18•81 = $9•53m
Overall value of the project = $9•53m – $2•98m = $6•55m
Since the project yields a positive net present value it would be accepted.