Reading 27 (Capital Budgeting) - EOC Question 50 investment, describes, otherwise

mar350

Another one where I can’t cotton to the CFAI answer of B. (“Timing options [e.g. delay investing] should be included in the NPV analysis, but sunk costs should not.”)
How does the delay-start timing option affect Hernandez’ NPV analysis? Absent any explicit indication otherwise, you would have to presume that the investment outlay won’t be committed until the project actually starts. Indeed, the case describes the project parameters as Hernandez’ “predictions” (i.e. of the future), and all the company has done to date is “announce plans”. Then Hernandez’ manager says the company is “considering delaying the *start* of the project” (emphasis mine).
If the start of the project is delayed, the NPV won’t change; nor will the parameters of the project necessarily change. What “changes” then should Hernandez implement to her analysis?
Seems to me answer should be A (“No.”), not B.
Any ideas/comments?
If none, I will forward to CFAI and post back any answer I receive.
Cheers!

sameeragarwal

Ahh, good point. That’s probably barking up the “right” tree.
Still…adding such a delay-start option into the NPV (capital budgeting) analysis, how? Delays can just as well be cost-inducing. Time-to-market and all that. If anything, if management is so uncertain about market reception, perhaps the right answer is to boost the discount rate to account for greater project risk. Now we’re getting somewhere… (But then why the heck wouldn’t CFAI put something along those lines in their “answer”?)
Obviously a lot of speculation. Would be a lot better if we could appreciate how Hernandez’ “analysis” is affected in a clear, at best quantifiable, way.
Thanks again.

ramdabom

I paused on this one too. But if you think about it, a postponed cash flow, even including the initial investment, will still have a different NPV now (at T0).
Example:
Cash Flow 1: -100…50…50…50
Cash Flow 2: 0…-100…50…50…50
At, say, a 10% discount rate, CF1 is worth 24.34, and CF2 is worth 22.13.
Essentially, by beginning the whole process one period later, you are reducing the value of that cash stream. Your original NPV, begun one period later, must be itself discounted by that one period. Money tomorrow is worth less than money today (assuming a positive discount rate); so an NPV at T1 is worth less today than that same unadjusted NPV “received” at T0 is.
It’s simple when you think about it. The confusion comes from the fact that both streams have identical IRRs (in this case, 23.4%) and identical outlays.
Option value is not really the point. In the example they are postponing implementation because they are unsure about their figures. If their figures were correct and the NPV positive, then postponing would have been costly. In this sense it is true to say that an option to proceed (or not) was essentially purchased, with the price being equivalent to the difference in expected NPVs of T0 and T1 implementation. Still, the option to delay is always present in every conceived project, and without having firmer figures to value (rather than price) this option, I feel it differs importantly from other fundamental options discussed in the reading. The main thing, I’m sure, is the additional discounted period.

troymo

Clear, makes sense. Nice job!
The difference in the cash-flows is the premium paid for the time option, and given issues like time-to-market risk and marketability uncertainty, Hernandez should perhaps also hike her project beta up a notch, but of course that’s a lot more of a subjective call. The delay in cash flows is not subjective, like you point out.