2. Investment timing options

Companies often need to choose between making an investment now or waiting till the company can gather more relevant information about the potential project. This opportunity to wait before making the decision is called the investment timing option.

Consider the case:

General Forge and Foundry Co. is considering a three-year project that will require an initial investment of $42,500. If market demand is strong, General Forge and Foundry Co. thinks that the project will generate cash flows of $29,500 per year. However, if market demand is weak, the company believes that the project will generate cash flows of only $1,250 per year. The company thinks that there is a 50% chance that demand will be strong and a 50% chance that demand will be weak.

If the company uses a project cost of capital of 12%, what will be the expected net present value (NPV) of this project?

General Forge and Foundry Co. has the option to delay starting this project for one year so that analysts can gather more information about whether demand will be strong or weak. If the company chooses to delay the project, it will have to give up a year of cash flows, because the project will then be only a two-year project. However, the company will know for certain if the market demand will be strong or weak before deciding to invest in it.

If the company accepts the project now, it would mean that the company is USING OR GIVING UP the option to make a more informed decision. If the value of the option is MORE OR LESS than the value of the project, then the company is more likely to use the option. The time before expiration for the investment timing option is one year. Considering these qualitative factors, the company SHOULD OR SHOULD NOT .

What will be the expected NPV if General Forge and Foundry Co. delays starting the project? (Note: Use the cost of capital to discount all cash flows.)

What is the value of General Forge and Foundry Co.s option to delay the start of the project?

What will be the expected NPV if General Forge and Foundry Co. delays starting the project? (Note: Use the cost of capital to discount all cash flows.)