Options Embedded in Projects

In chapter 5, we examined the process for analyzing a project, and deciding whether or not to accept the project. In particular, we noted that a project should be accepted only if the returns on the project exceed the hurdle rate; in the context of cash flows and discount rates, this translates into projects with positive net present values. The limitation with traditional investment analysis, which analyzes projects on the basis of expected cash flows and discount rates, is that it fails to consider fully the myriad options that are usually associated with many projects.

In this section, we will analyze three options that are embedded in capital budgeting projects. The first is the option to delay a project, especially when the firm has exclusive rights to the project. The second is the option to expand a project to cover new products or markets some time in the future. The third is the option to abandon a project if the cash flows do not measure up to expectations.

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