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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

A mining company holds the right to close a mine permanently if metal prices fall below a certain level. In a capital budgeting analysis, including this real option will most likely:

Including the abandonment option will most likely increase the project's NPV. The option acts like a put, limiting losses when prices fall. Its value is positive even if it is exercised only in poor outcomes, so the project is worth more than the static NPV suggests.

  1. Adecrease the project's NPV because of the added cost
  2. Bincrease the project's NPV because losses are limitedCorrect
  3. Cleave the project's NPV unchanged because the option is exercised only in bad outcomes

Explanation

An abandonment option works like a put option. It limits downside losses, so it adds value, and the project's NPV including the option exceeds the NPV without it. The unchanged-NPV choice is wrong because the option's possible exercise still has value today.

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