Hi! A doubt on real options: Say that, in 2 years, I have a real option to expand. If I exercise the option, I have to invest $3M, and will have cash inflows of $1M perpetually. If my cost of capital is 20%, then the expected value of the inflows, AT YEAR 2, is 1/20%=5. But real options require the NPV of the inflows at YEAR 0! My question is: what rate should I discount the value 5 from year 2 to get the present value? Should it be the same as my cost of capital (because cash flows are uncertain)? Should it be the risk-free rate (because I have not committed to the project?)?

Question

Hi! A doubt on real options: Say that, in 2 years, I have a real option to expand.  If I exercise the option, I have to invest $3M, and will have cash inflows of $1M perpetually.  If my cost of capital is 20%, then the expected value of the inflows, AT YEAR 2, is 1/20%=5. But real options require the NPV of the inflows at YEAR 0!   My question is: what rate should I discount the value 5 from year 2 to get the present value?   Should it be the same as my cost of capital (because cash flows are uncertain)?   Should it be the risk-free rate (because I have not committed to the project?)?

anonymous · Answer

Is this similar to a problem that you have seen before?

anonymous · Answer

Hi tomservo; yes, I'm trying to evaluate an expansion project by real options.  I have expected cash flows for the project in the future, the necessary investment to "exercise the option", and the cost of capital for this asset.  This gives me the value of the project at the time of the expansion (year=T).  But I do not know what the NPV of the project should be (at the year=0).     Since I have not made a commitment to carry out the project, shouldn't I discount  to value at time=T to the present at the risk-free rate?    But, since the cash flows are uncertain, should I discount at the project's cost of capital?

anonymous · Answer

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