Option to Defer Investment

Based on the positive net present value, management may agree to invest in Nyhamna as a potential hub. On the other hand, they may also consider the best time to invest. They may consider whether they will get more pay off when they wait to invest in the second year instead of the current year. The management could defer the investment of overcapacity at the end of year three and wait until finding the new gas fields. Now assume they have the right to defer undertaking the project for a year after finishing the first stage. All the costs are the same as noted before. Another option is that do not invest until finding new gas fields. To simply the calculation, we do not combine these options together and only analyze one option each time.

As calculated before, the present value at current year is NOK 33.4 million. This means if Nyhamna exist as a hub today, the value would be NOK 33.4 million (without option). It is possible that this value would go up or down in the next year. Based on the gas price, the up and down factors are 1.5 and 0.75, respectively. In the first year, the value of this hub would be worth either NOK 50 million or NOK 25 million. If the value falls to NOK 25 million, the year two potential values are NOK 37.5 million and NOK 18.75 million. If the value of this hub goes up to NOK 50 million, the year two potential values are NOK 75 million and NOK 37.5 million.

The potential values of becoming a hub at Nyhamna are shown in figure 4.5. These numbers show how much the hub could worth at each stage of the project’s life. At the end of year four, four potential values are NOK 169 million, NOK 84 million, 42 NOK million and NOK 10.5 million, respectively. Since the investment cost is NOK 11 million, management would abandon the investment when the potential value is NOK 10.5 million.

If they abandon the project, the value of this hub is zero. Otherwise, the value at the end of year four is the difference between the value of this hub at the end of year four and the cost of investment.

Figure 4.5: Decision tree of valuing a hub at Nyhamna

Work back from the end of year four to determine the project’s potential values at the end of year three. In each scenario, if the value is larger than the exercise price, the management may keep the option open which means they will defer the decision of investing Nyhamna as a hub. On the contrary, the management may exercise the option when the value is less than the exercise price. Look at the last scenario at the end of year three, the number is greater than the value of exercising the option by investing Nyhamna as a potential hub. The right choice for management, therefore, is to defer invest and keep the option alive. Similar to this, step back to the current year to calculate the project’s present value in order to determine that whether it merits the up-front investment. The

result here is NOK 22.9 million which is greater than the initial investment (22.9>21.4).

This positive result means it is worth to invest in Nyhamna as a potential hub. The simplified model described previously helps management to understand the best time to exercise the option. In other words, it is always optimal to delay the option of investing in Nyhamna as a hub until maturity.

As mentioned above, the expanded (strategic) NPV = Static (passive) NPV+ Option premium. That means the value of the option to defer investment for developing Nyhamna as a hub is thus given by

Option premium= expanded (strategic) NPV- Static (passive) NPV = 22.9-12

= NOK 10.9 million

This result is equal to almost one-third of the project’s gross value (NOK 33.4 million).

The objective of using real option theory is to help the management consider about the value of Nyhamna as a hub today and how that value might change over time. The positive result shows that it is a good strategy to exercise the option to defer. The management probably decide not to invest in Nyhamna as a hub right now and they prefer to wait.

In this case, Onyx and Luva may not be able to land to Nyhamna. Instead, they may wait until new capacity available at an alternative hub. It is possible to land them to an existing hub--Åsgard. As mentioned before, the capacity at Åsgard was filled up already and there is no available capacity for these two new fields now. However, the management could wait until 2021 and there might have available capacity at Åsgard at that time. In addition, the management might have to get much cash flow if landing Onyx and Luva to Åsgard because they have to cover the cost of waiting for available capacity at Åsgard.

Another solution is waiting to develop a new gas hub which combines four new gas fields (Victoria, Gro, Onyx and Luva). These four new gas fields are located nearly. Victoria and Gro are two big new gas fields. It is possible to build up a new hub and land Onyx and Luva there. This solution might not be so good because the initial investment cost might be very high.