ASSESSING THE VALUE OF AN OPTION IN PROJECT APPRAISAL
A recent conversation with a friend touched on the issue of making provision in a project for future development. Sometimes, although one knows that the current project scope will not meet the needs of the future, the organisation cannot afford that future provision just now. However it is sometimes obvious to those close to the project that there are relatively inexpensive ways of making it easier to realise a future project by making some provision in the current one. You may have heard the terms passive provision and active provision.
I think the boundary between passive and active provision is blurred. They are both steps in a current project which make it easier to realise a future project. Passive will be cheaper than active provision, and may be focussed more on ensuring that the future project is possible rather than building part of it now. An example near me is a section of the A350 where the existing road has a corridor of land reserved alongside it. By not building on that corridor, we can say that passive provision is made for widening the road in the future. By building bridges which span both the existing road and the land reserved for widening we can say that active provision has been made.
The question is how can we assess the value of making provision now for a future development?
We can probably quite easily assess the cost of reserving the land, as land has a value. We can also assess the cost of building bridges of twice the span necessary now. But the value that it brings, how do we assess that? We are giving ourselves an option to widen the road in the future, and the financial world has a formula for valuing options. It’s called the Black-Scholes formula.
In the financial world a call option is the option to buy something, e.g. a share, at sometime in the future, at a price we can fix now (the exercise price).
The value of the option is a function of:
- The exercise price of the investment. How much would it cost now to build the wider road.
- The forecasted value of the benefits of the investment.
- The duration of the option
- The interest rate
- The uncertainty inherent in the future investment cashflows
The word “function” hides some interesting maths including logarithms, square roots and probability distributions. There are calculating tools on the web. For project sponsorship purposes the interesting things to grasp are that:
- The greater the uncertainty about what the future project is worth, the greater the value of the option. If you know now that the future investment easily pays for itself, do it now, why do you need to wait?
- The longer the length of time the option gives you to make your decision to invest, the more valuable it is.