However, after taking account of Swan Co’s offer and the finance director’s assessment, the net present value of the project is positive. For instance, if an individual withdraws from an employment contract containing an abandonment clause, the employer cannot contest his resignation. = $37,049,300 The BSOP model requires further assumptions to be made involving the variables used in the model, the primary ones being: (a) The BSOP model assumes that the underlying project or asset is traded within a situation of perfect markets where information on the asset is available freely and is reflected in the asset value correctly. Volatility (s) = 50%. Therefore, where an organisation has some flexibility in the decision that has been, or is going to be made, an option exists for the organisation to alter its decision at a future date and this choice has a value. Based on the facts that the company can delay its decision by two years and a high volatility, it can bid as much as $9.6m instead of $5.8m for the exclusive rights to undertake the project. The volatility (s), which is the risk attached to the project or underlying asset, measured by the standard deviation. In any given situation, one or more of these assumptions may not apply. A company is considering bidding for the exclusive rights to undertake a project, which will initially cost $35m. Pearson Education, Essex, UK. At present the cost of $140m seems substantial compared to the present value of the cash flows arising from the second project. The expansion would involve undertaking a second project in four years’ time. It could even consider the possibility that it may be able to sell the combined rights to both projects for $23.8m. Solution: NPV with the option to delay the decision for two years, Variables to be used in the BSOP model Whereas for traded financial assets this would most probably be the case, as there is likely to be sufficient historical data available to assess the underlying asset’s volatility, this is probably not going to be the case for real options. Solution: The standard deviation of the project’s cash flows is likely to be 40% and the risk free rate of return is currently 5%. (iii) The option to exploit follow-on opportunities which may arise from taking on an initial project (which is a type of call option). The article then considers the limitations of the application of real options in practice and how some of these may be mitigated. Is This The Ultimate Value Investing Model? Further it assumes that a market exists to trade the underlying project or asset without restrictions (that is, that the market is frictionless) With real options, a similar situation may occur when the possible actions of competitors may make an exercise of an option before expiry the better decision. The value computed can therefore be considered indicative rather than conclusive or correct. A lot could happen to the cash flows given the high volatility rate, in that time. * The business evidence section is for premium members only. In this paper, real options, and more specifically the option to abandon, are analysed as a complement to cash flow sequence which quantifies the project. Arnold, G. (2008) Corporate Financial Management. The Chartered Institute of Management Accountants, Oxford, UK. The global body for professional accountants, Can't find your location/region listed? Risk free rate (r) = 4.5% The option itself is included explicitly as part of a contract's terms and specifies that neither party will incur any penalties should either of them withdraw from (abandon) the contract. Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the present values of the project’s cash flows as follows: Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year three. Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real option computation below, indicates that the project is worth pursuing because the volatility may result in increases in future cash flows.