Ways of Computing the Value of Alternative Projects Essay -- Finance F

Ways of Computing the Value of Alternative Projects When deciding whether to invest in a project an investor first will compare investment or sunk costs to the expected profit and based on this decision will decide what to do. Depending on the specifics of the project calculating of sunk cost and expected profit might be rather different and will play the main role in the decision to invest, wait and invest later or not to invest at all. More detailed consideration of the standard NPV rule: to invest if present value of cash flow is greater than sunk cost will show that some projects cannot be simply estimated using this idea. For the irreversible projects such as building a factory or buying an option NPV method may not be proper because it does not take into consideration the opportunity cost of waiting for new information, and, then investing. In other words, if investor knows that the price of the product producing on the factory will go down or the product will not be sold at all, because of some new competitive product, he will most likely choose not to build it at all. Now, different investment opportunities may be taken into consideration, for example, building the factory in steps or start using the factory for a different use. Let us calculate a value of the project using regular NPV rule and NPV rule that takes into consideration time effect or this opportunity to wait and invest later. These calculation have been done by many researchers, but Pindick and Dixit in their book Investment Under Uncertainty propose very easy way to compare different results. We will just use their idea but with a simpler numbers and show how different ways of computing provide different results. On this simple example we can lear... ...umption of presenting net present value as a geometric Brownian motion is the most important one and has been implemented in the financial field for a while. Empirical works by financial institutions have shown that such assumption lets investors obtain reasonable results and plan the investment in advance. This technology has been also used in reducing risk on the portfolios when hedging. The obtained results can be easily implemented in the options pricing theory and were applied by Pindick and Dixit in the works. With all the assumptions the model shows realistic results and have been used by many financial institutions since 1980s. References 1. Investment Under Uncertainity, Avinash Dixit and Robert Pindick, Princeton University Press, 1994 2. Investment timing, Robert McDonald and Daniel Siegel, The Quarterly Journal of economics, v.111, 1986