Valuing the Option to Delay the Start of a Manufacturing Project

Strategic options affect a variety of investment decisions. The condominium example

in the last subsection illustrated the value of delay, which permitted some flexibility in

the size of the condominium structure. Delay has value because it provides the devel-

oper with more time to determine the condominium building with the size best suited

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436Part IIIValuing Real Assets

for future economic conditions. The optimal building size cannot be known until eco-

nomic conditions unfold over time.

Delay also allows the firm more time to decide whether to adopt a project. When

a firm accepts a project, it exercises an option and, hence, loses the value from wait-

ing longer. The value of waiting makes it imprudent to exercise an American call option

on a nondividend-paying stock before the option’s expiration date (see Chapter 8). This

lesson should not be forgotten when dealing with the strategic options of a real asset.

While the future cash flows of a real asset may not exactly mimic the future cash flows

of an American call option, the generic lesson is the same: For the call option, delay

exercise until the last possible moment. For the real asset, it is often better to delay

accepting a project even when the project currently has a positive “net present value,”

as computed by discounting its direct cash flows.

To understand why this value from delay arises, think about each project as a com-

bination of two or more mutually exclusive investments that are defined by the time they

are first implemented. For example, investment 1 might be to initiate the project imme-

diately, while investment 2 is to wait one year and then initiate the project only if eco-

nomic conditions are favorable. Initiating the project immediately may be a positive net

present value (NPV) investment, but the NPVof waiting one year may be even higher.⁸

Viewed from this perspective, it might make sense to turn down positive net pres-

ent value projects, at least temporarily, as Example 12.5 illustrates. In this example, it

pays to turn down the positive NPVproject at year 0, and in year 1 adopt the project

if the good state occurs, and reject the project if the bad state occurs.

Example 12.5:Creating Value by Rejecting a “Positive NPVProject”

Acme Industries is considering building a plant.After an initial investment of $100 million,

the plant will be completed in one year and then have the series of annual cash flows shown

in Exhibit 12.5.Acme’s managers can decide to immediately invest the $100 million, or they

can wait until next year to decide whether to build or not.

If the project is built immediately, panel A in Exhibit 12.5 shows that after a year of start-

up procedures, next year’s cash flow will be $10 million, but a perpetual annual cash flow

stream of either $15 million or $2.5 million will occur each year thereafter, depending on

whether the economy is good or bad one year from now.If the project is delayed, panel B

of Exhibit 12.5 shows that the first year’s initial $10 million cash flow will be lost.Only the

perpetual cash flow stream of $2.5 million or $15 million, beginning two years hence, will be

captured, depending on the state of the economy in year 1.Assuming that the risk-free inter-

est rate is 5 percent per year and that $1.00 invested in the market portfolio today will be

worth either $1.30 (if the economy does well) or $0.80 (if the economy does poorly), com-

pute the NPVof the project and decide whether or not it pays to wait.

Answer:View the decision to wait or build now as two mutually exclusive projects with

the higher NPVproject winning out.Each of the two projects can be valued as a derivative

using the binomial option valuation methodology.First, compute the value of the plant if Acme

builds it immediately.

If the market return is good, the plant has a year 1 value of $10 million plus the value of

the perpetuity;that is

$15 million

$10 million $310 million

.05

⁸Ingersoll and Ross (1992) note that even if the manager knows that cash flows will not change as a

result of waiting to invest, the present values of cash flows will change because interest rates are always

changing. Hence, every project can be viewed as an option on interest rates.

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Chapter 12Allocating Capital and Corporate Strategy437

EXHIBIT12.5Cash Flows forAcme’s Factory Timing Decision in Example 12.5

Panel A: Do Not Wait

Year 0 Year 1 Year 2 Years 3, 4, 5, . . .

$10 million	$15 million	$15 million per year forever
		. . .
Good

–$100
million
	$10 million	$2.5 million	$2.5 million per year forever
			. . .
	Bad

Panel B: Wait One Year and Initiate Only in the Good State

Year 0 Year 1 Year 2 Years 3, 4, 5, . . .

–$100 million	$15 million	$15 million per year forever
		. . .
Good

$0

$0	$0	$0 per year forever
			. . .
Bad

If the market return is bad, the year 1 value is

$2.5 million

$10 million $60 million

.05

To compute the present value, calculate the risk-neutral probabilities, and 1 ,associ-

ated with the valuation of the market portfolio.These solve

($1.30)(1 )($.80)

$1.00

1.05

implying that .5.Applying the probabilities and 1 to the relevant values in the

two states yields a present value for the plant of

(.5)$310 million (.5)$60 million

$176.19 million

1.05

Since this is greater than the $100 million cost of building the plant, the project has a pos-

itive net present value of $76.19 million ( $176.19 million $100 million).

The alternative of waiting one year and then investing in the plant only if the favorable

outcome occurs results in a net present value of

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Strategy, Second Edition

438Part IIIValuing Real Assets

$15 million/.05 $100 million

.5 $95.24 million

1.05

Since $95.24 million exceeds $76.19 million, the alternative of waiting is preferred.

Example 12.5 illustrates the following point:

Result 12.4

Most projects can be viewed as a set of mutually exclusive projects. For example, takingthe project today is one project, waiting to take the project next year is another project, andwaiting three years is yet another project. Firms may pass up the first project, that is, foregothe capital investment immediately, even if doing so has a positive net present value. Theywill do so if the mutually exclusive alternative, waiting to invest, has a higher NPV.