Give an example of an option to delay a project. Why might this be of value?
What will be an ideal response?
There is no question that the estimated cash flows associated with a project can change over time. In fact, as a result of
changing expected cash flows, a project that currently has a negative net present value may have a positive net present
value in the future. The ability to delay this project with the hope that technological and market conditions will change,
making this project profitable, lends value to the project and it is called an option to delay. An example of the option to
delay a project until the future cash flows are more favorable could be a firm that owns the oil rights to some oil-rich
land and is considering an oil-drilling project. Suppose that after all of the costs and the expected oil output are
considered, the project has a negative net present value. Does that mean the firm should give away its oil rights or that
those oil rights have no value? Certainly not. There is a chance that in the future oil prices could rise to the point that
this negative NPV project could become a positive NPV project. It is this ability to delay development that provides
value. Thus, the value in this seemingly negative NPV project is provided by the option to delay it until the future cash
flows are more favorable.
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