This is because, while the option to invest still has a life, there's a non-zero chance that underlying circumstances might change to make the project positive NPV. Even when the present value of the cash flows from commencing operations is less than the investment outlay required. As you can see, prior to expiry, the value of the option to invest is positive. The interesting bit comes about when we look at the value of the option to invest, as represented by the curved green line. Then the project has a negative NPV, and you wouldn't invest in them. Conversely, at expiry of the option, if the initial investment required were to be greater than the present value of the cash flows promised by the project. So at expiry of the option, if the present value of the cash flows promised by the project exceed the initial investment outlay required, then the project has a positive NPV and would be entered into. You might recall from our previous discussions of options back in course three of the specialization, that the straight red line represents the intrinsic value of the option. So here, the straight red line represents the payoff from the option at expiry, or when the option is exercised. Well, let's have a look at the payoff diagram for this option. And the term to expiry of the option is simply the period of time you have until you no longer have the right to invest in the project. The volatility of the underlying returns is reflected in the forecast variability of the cash flows promised by the project. The option premium is the price that you pay for the option and reflects in a project setting, the amount spent so as to build the flexibility in your operations. The underlying asset that you're purchasing is the equal to the present value of the net cash flows from operating the project. The key feature of this option, is that it's a call option, where the exercise price that you pay when you exercise the option is equal to the up front investment required when you choose to go ahead with the project. So let's begin with the option to invest, or to delay investment. The option to expand operations in response to a positive change in market conditions, and finally, the option to abandon operations as market conditions change adversely and significantly against the firm. So in this session, we're going to discuss the option to invest or to delay investment, which is really just the other side of the same coin. It's now opportune for us to identify the key types of real options that companies come into contact with on a regular basis. So having identified the fact that NPV analysis might lead to incorrect decision making, if it fails to account for the flexibility that management might have in how it conducts its operations.
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