Why might the recognition the existence of a real option raise, but not lower a

Question

Why might the recognition the existence of a real option raise, but not lower a project's NPV compared to that found in the traditional manner? 4. A convertible bond gives the investor the right to convert a corporate bead with a face amount of $1000 into a specific number of shares of stock. Since the conversion will increase the number of shares and dilute the ownership percent of each shareholder owns, why should a current shareholder be in favor of forcing bondholders to convert their bonds to shares?

Explanation / Answer

NPV method is a discounted cash flow method that is more suitable for the valuation of bonds and stock. Though, it is also most popularly used in capital budgeting process, but it does not capture the true value. It happens because capital budgeting involves investment in real assets that act as real options and it is an active investment in comparison to the valuation of bonds and stocks that are considered as a passive investment. Thus, advantage of real options such as modified action plan in future is not captured by traditional DCF methods such as NPV. So, the actual value of capital budgeting is not reflected by NPV method.

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