Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 14. Options and Corporate
Finance© The McGraw−Hill^501
Companies, 2002higher-efficiency one. This type of investment can be made now or later. In this case, the
option to wait may be very valuable.
There is another important aspect regarding the option to wait. Just because a project
has a negative NPV today doesn’t mean that we should permanently reject it. For ex-
ample, suppose an investment costs $120 and has a perpetual cash flow of $10 per year.
If the discount rate is 10 percent, then the NPV is $10/.10 120 $20, so the proj-
ect should not be taken now.
We should not just forget about this project forever, though. Suppose that next year,
for some reason, the relevant discount rate fell to 5 percent. Then the NPV would be
$10/.05 $120 $80, and we would take the project (assuming that further waiting
isn’t even more valuable). More generally, as long as there is some possible future sce-
nario under which a project has a positive NPV, then the option to wait is valuable, and
we should just shelve the project proposal for now.
Managerial Options
Once we decide the optimal time to launch a project, other real options come into play.
In our capital budgeting analysis thus far, we have more or less ignored the impact of
managerial actions that might take place aftera project is launched. In effect, we as-
sumed that, once a project is launched, its basic features cannot be changed.
In reality, depending on what actually happens in the future, there will always be op-
portunities to modify a project. These opportunities, which are an important type of real
options, are often called managerial options. There are a great number of these options.
The ways in which a product is priced, manufactured, advertised, and produced can all
be changed, and these are just a few of the possibilities.
For example, in April 1992, Euro Disney (ED), the $3.9 billion, 5,000-acre theme
park located 20 miles east of Paris, opened for business. The owners, including Walt
CHAPTER 14 Options and Corporate Finance 473The Investment Timing Decision
A project costs $200 and has a future cash flow of $42 per year forever. If we wait one year,
the project will cost $240 because of inflation, but the cash flows will be $48 per year forever.
If these are the only two options, and the relevant discount rate is 12 percent, what should we
do? What is the value of the option to wait?
In this case, the project is a simple perpetuity. If we take it today, the NPV is:
NPV $200 42/.12 $150
If we wait one year, the NPV at that time would be:
NPV $240 48/.12 $160
So, $160 is the NPV one year from now, but we need to know the value today. Discounting
back one period, we get:
NPV $160/1.12 $142.86.
If we wait, the NPV is $142.86 today compared to $160 if we start immediately, so the opti-
mal time to begin the project is now.
What’s the value of the option to wait? It is tempting to say that it is $142.86 $160
$17.14, but that’s wrong. Why? Because, as we discussed earlier, an option can never have
a negative value. In this case, the option to wait has a zero value.EXAMPLE 14.4managerial options
Opportunities that
managers can exploit if
certain things happen in
the future.