The Investment Timing Decision

Consider a business that is examining a new project of some sort. What this normally means is management must decide whether to make an investment outlay to acquire the new assets needed for the project. If you think about it, what management has is the

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

14. Options and Corporate Finance

© The McGraw-Hill Companies, 2002

PART FIVE Risk and Return investment timing decision

The evaluation of the optimal time to begin a project.

right, but not the obligation, to pay some fixed amount (the initial investment) and thereby acquire a real asset (the project). In other words, essentially all proposed projects are real options!

Based on our discussion in previous chapters, you already know how to analyze proposed business investments. You would identify and analyze the relevant cash flows and assess the net present value (NPV) of the proposal. If the NPV is positive, you would recommend taking the project, where taking the project amounts to exercising the option.

There is a very important qualification to this discussion that involves mutually exclusive investments. Remember that two (or more) investments are said to be mutually exclusive if we can take only one of them. A standard example is a situation in which we own a piece of land that we wish to build on. We are considering building either a gasoline station or an apartment building. We further think that both projects have positive NPVs, but, of course, we can take only one. Which one do we take? The obvious answer is that we take the one with the larger NPV.

Here is the key point. Just because an investment has a positive NPV doesn't mean we should take it today. That sounds like a complete contradiction of what we have said all along, but it isn't. The reason is that if we take a project today, we can't take it later. Put differently, almost all projects compete with themselves in time. We can take a project now, a month from now, a year from now, and so on. We therefore have to compare the NPV of taking the project now versus the NPV of taking it later. Deciding when to take a project is called the investment timing decision.

A simple example is useful to illustrate the investment timing decision. A project costs $100 and has a single future cash flow. If we take it today, the cash flow will be $120 in one year. If we wait one year, the project will still cost $100, but the cash flow the following year (i.e., two years from now) will be $130 because the potential market is bigger. If these are the only two options, and the relevant discount rate is 10 percent, what should we do?

To answer this question, we need to compute the two NPVs. If we take it today, the NPV is:

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