Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 28

The Option to Delay and Valuation Implications

In traditional investment analysis, a project or new investment 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 investing in projects with positive net present values (NPVs). The limitation of this view of the world, which analyzes projects on the basis of expected cash flows and discount rates, is that it fails to consider fully the options that are usually associated with many investments.

This chapter considers an option that is embedded in many projects, namely the option to wait and take the project in a later period. Why might a firm want to do this? If the present value of the cash flows on the project are volatile and can change over time, a project or technology that does not pass muster now may become valuable in the future. Furthermore, a firm may gain by waiting on a project even after a project has a positive net present value, because the project may have a higher value taken at a future date. This option is most valuable in projects where a firm has the exclusive right to invest in a project and becomes less valuable as the barriers to entry decline.

There are at least three cases where the option to delay can make a difference when valuing a firm. The first is undeveloped land in the hands of real estate investor or company. The choice of when to develop rests in the hands of the owner, and presumably development ...