Question

You are considering a project with a discount rate of 10%. If you start the project today, you will incur an initial cost of $500 and will receive cash inflows of $350 a year for three years. If you wait one year to start the project, the initial cost will rise to $515 and the cash flows will increase to $365 a year for three years. What is the value of the option to wait (the difference in NPV today between doing the project immediately and waiting one year to start)?

Answer 1

Hi

If the project starts today

then Y0 cash flow = -$500

Y1 cash flow = $350

Y2 cash flow = $350

Y3 cash flow = $350

discount rate r = 10%

so NPV if project starts today = -500 + 350/(1+10%) + 350/(1+10%)^2 + 350/(1+10%)^3

NPV = -500 + 350/1.1 +350/1.1^2 + 350/1.1^3

NPV = $370.398

IF project start after 1 year

then Y1 cash flow = -$515

Y2 -Y4 cash flow = $365

so NPV = -515/1.1 + 365/1.1^2 +365/1.1^3 + 365/1.1^3

NPV = $357.0009

So the value of option (difference between NPV of both projects) = 370.398 - 357.0009 = $13.397

Thanks