Contrast the difference between the NPV of an investment and the value of the option to invest in it.
I.The value of the option to invest increases with interest rates while the NPV decreases.
II.The value of the option to invest decreases with an increase in short-term cash flows while NPV increases.
III.The value of the option to invest and the NPV of the project are unrelated.
A)I only
B)II only
C)III only
D)I and II only

Question

Quizplus · Accepted Answer

I is true because an increase in interest rates means a higher discount rate, which decreases the net present value (NPV) of the investment. However, a higher interest rate increases the time value of money and makes the investment more attractive as an option.
II is also true because an increase in short-term cash flows means more money available to invest, which decreases the value of the option to invest since there is less need for it. However, the increase in cash flows can increase the NPV of the investment.
III is false as there is a relationship between the option value and the NPV, as the option value is part of the NPV calculation for investments with options.

Contrast the Difference Between the NPV of an Investment and the Value