Discounted Cash Flows and Options

Conventional NPV analysis discounts a project's cash flows estimated for a certain project life. The decision is whether to accept the project or reject it. In practice, managers can expand or contract the scope of a project at various moments over its life. In theory, all such managerial options should be included in the project's value.

The market value of the project (M) will be the sum of the NPV of the project without options to expand or contract and the value of the managerial options (Opt):

Example-

Imagine two ways of producing Frisbees. Method A uses a conventional machine that has an active secondary market. Method B uses highly specialized machine tools for which there is no secondary market. Method B has no salvage value, but is more efficient. Method A has a salvage value, but is inefficient.

If production of Frisbees goes on until the machines used in methods A and B are used up, the NPV of B will be greater than that of A. However, if there is some possibility that production of Frisbees will be stopped before the end of the useful life of the Frisbee-making machines, method A may well be better. Method A's higher value in the secondary market increases its NPV relative to B's. There is a valuable embedded option to abandoning Method A.

Ross-Westerfield-Jaffe: II. Value and Capital Corporate Finance, Sixth Budgeting Edition

8. Strategy and Analysis in Using Net Present Value

© The McGraw-Hill Companies, 2002

Part II Value and Capital Budgeting

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