When is it optimal to defer an investment and how is the deferral option valued?

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AcadiFi · Accepted Answer

A deferral option is the right to postpone investment — equivalent to an American call on the project...

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For Greenriver: developing now costs $40M, yielding PV of $48M — NPV = $8M. The naive rule says build. But if the volatility of development value is 30%, risk-free is 4%, and the option to defer lasts T = 3 years, a binomial tree values the call at around $13M. Waiting is worth $5M more than building today.

The optimal rule is to build when S exceeds a threshold S* that depends on volatility, opportunity cost of delay (forgone cash flows or land carry), and the remaining option life. The more uncertain the future, the higher S* — which means even highly positive-NPV projects optimally wait.

Key intuition for AcadiFi Level II candidates: the value of waiting comes from avoiding downside while preserving upside. If Greenriver develops immediately and the market softens, the $40M capex is sunk. By deferring, Greenriver pays only if conditions still justify it.

Caveats: (1) Deferring has costs — lost rental income, risk of land-use changes, competitors capturing the market. Model these as 'dividend yield' on the underlying. (2) Options to defer are often shorter than entitlements suggest due to regulatory, political, or contractual constraints. (3) High volatility favoring waiting doesn't license indefinite procrastination; eventually the option expires.

When is it optimal to defer an investment and how is the deferral option valued?

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