Here is a simple example.
A firm can scale back by eliminating a negative cash flow project after the first period.
There is a 60% probability of $20 per year forever or 40% probability of -$6 per year forever.
The discount rate is 10%.
Without an option to cancel
If the initial cost today is $100, then without an option to cancel, the NPV would be:
-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/0.10) = -$4
With an option to cancel after the first year
With the option to abandon after the first year, the NPV would be:
-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/1.10) = $17.82
The value of the option to cancel the project is the difference, or $21.82
The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.
The real-option valuation (ROV) and decision tree analysis (DTA) are the two primary methods of valuation.
- Both depend on forecasting based on contingent states of the world.
- Although ROV is often a better methodology to use than DTA, it is not the right approach in every case.