NPV and its Now or Never Problem

NPV method assumes that the decision is Now or Never. This creates a challenge sometimes.

But sometimes you have an option to delay the decision.

Assume an Oil company has exclusive rights to extract oil from a well. These rights are for 20 years.

The overall reserves are assumed to be 100 million barrels. The cost of developing the well is $12 billion (approx $120 per barrel)

Given that the current price of oil is around $80 per barrel, this oil well is not viable.

If we take current oil prices for analysis, the NPV would be negative, which means one would reject the project.

But what if the oil price goes up in future? Or if the company is able to discover more reserves without any additional cost in the same location, such that overall reserves are 200 million barrels.

If this oil well and the exclusive right to extract oil is sold by the company, surely it will sell for some price?

NPV – since it assumes that the decision is now or never, is not able to address this completely.

So what do we do?

To get a fair value, we have to incorporate the possibility of oil prices going higher, or more reserves discovered, such that this project becomes viable.

This can be addressed in 2 ways

1) Either by attributing some value to the reserves, using comparable valuations of other such companies OR

2) By using what is called the Real Option Valuation. Since we have the option to start production at some point over the next 20 years, subject to viability.

Keep in mind that businesses may be thinking of optionality when acquiring exclusive rights to something. They may not just be relying on NPV analysis.

Also, important note to end the post: FinShiksha does not send any email asking for your username or password or any other confidential information. As a safe internet practice, please do not respond to any such emails.

That’s it for this week. Till next week. Keep Learning.