Determine the value of the option for the Weyer Company by delaying its investme

Question

Determine the value of the option for the Weyer Company by delaying its investment for one year.

Consider the value of the option is the difference between traditional present value analysis and real option analysis. The initial investment is for $9,700,000, but the investment will not be made until next year. The investment is being delayed so that Weyer’s management can better determine the market for their product. There are two alternatives for sales in the next year of $13,000,000 or $8,000,000. Each sales level has an occurrence probability of 50%. The cost of capital for Weyer is 10%. If traditional present value analysis shows that the net present value of the project is $300,000, what is the value of the option (the ability to wait one year before executing or abandoning the project)?

a. $11,800,000

b. $662,810

c. $3,300,000

d. $472,565

e. None of the above.

Explanation / Answer

Under Real Option Analysis:

Time to expiration = 1 year

Cost of Capital = 10%.

If the Sales next year is 13,000,000, the NPV of the Project is:

-9,700,000 + 13,000,000/(1+10%) = 2,118,182

If the Sales next year is 8,000,000, the NPV of the Project is:

-9,700,000 + 8,000,000/(1+10%) = -727,273

However, if the sales is $8M, we would not undertak the project and hence the actual value is 0.

Now using the probability we can arrive at the value of the option as:

(2,118,182 X 0.5 + 0 X 0.5)/(1+10%) = 962,810

Since the value of the option is the difference between this and the traditional PV analysis the answer is :

962,810 - 300,000 = 662,810.

The answer is b

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