A simple Real option example

Here’s an example from Dixit and Pindyck (pp. 26-35). Suppose a firm is trying to
decide whether to buy a machine. The investment is irreversible. We can purchase
the machine today at a cost, I, and the machine will produce one unit of output per
year forever, with zero operating cost. The current output price is $200, but next
year the price will change. With probability q, it will rise to $300, and with
probability (1-q), it will fall to $100. The price will remain at the new level forever. To
keep things simple, we assume that the price risk is fully diversifiable, so we discount
cash flows at a riskless rate of 10%. Let I = $1600, and q = 0.5. Given these values, is
this a good investment?
NPV = -1600 +200 +[(0.5)300+(0.5)100]/0.1
= -1600+2200 =+$600

Opportunity cost of immediate purchase?

By waiting, we resolve price uncertainty

NPV of purchase next year:

NPV = (0.5)[-1600/1.1 +300/0.1] + (0.5)0 =+773
In year 1, the $1600 is spent only if the price rises to $300, which will happen with
probability 1/2. If our only choices are to invest tpday, or never invest, we would
invest today. Two things are required in order to generate an opportunity cost to
investing today:
(1) A degree of irreversibility, and
(2) The ability to invest in the future as an alternative to investing today.

How much is it worth to have the flexibility to make the investment decision next
year, rather than a now or never decision today? An estimate of the value of this
flexibility option is the difference between the two NAP’s we calculated above, i.e.,
$773-$600 =$173.

That is, option value = NPV purchase next year - NPV purchase today
=$773 -$600 =$173

Another way to look at this is to ask the question, “ how high an investment cost, I,
would we be willing to accept to have a flexible investment opportunity rather than a
‘now or never’ one?” That is, we can solve for the value for I that makes the value of
the delayed project equal to the immediate project:

NPV = (0.5)[-I/1.1 +300/0.1] =600

Solving for I, we get I =$1980

That is, altervative :

Ibreakeven : NPV = (0.5)[-I/1.1 +300/0.1] =600
Ibreakeven =$1980