Imagine you have an asset (a share in a business, a factory, real estate) from which the expected cash flows’ PV is lower than its current market price. Do you think you should sell it?
Let’s assume you own a share in a business that pays you dividends annually, according to profitability. Based on your opportunity cost of capital, the expected dividends’ PV is $5 million.
Now, let’s assume that one of the partners, who owns a larger share (making it more valuable to him), offers you $5.5 million. This means an immediate decision would yield you a profit of $500,000.
You have one year to decide, giving you a PUT option that has its own value.
Should you sell?
If we use the Black-Scholes model to evaluate the option and assume that the risk-free rate is 4% and the standard deviation of the expected dividends is 30%, we find that the option’s value is $768,000. This means the live option is worth more than the immediate sale result (i.e., $500,000).
Intuitively, since you have calculated the PV of dividends based on expected cash flows, but there is a probability that these expected flows may significantly change by the end of the year, either positively or negatively, you should wait to see how things develop. If things go poorly, you can sell the share, but if they improve, you can retain it.
It’s important to understand that waiting is not always the right choice. For example, if we reduce the uncertainty range or standard deviation, or increase the risk-free rate, then the option’s value will decrease… and at some point, it will lose its relevance.
P.S.
I understand that the model is simplified and in the real world, many other factors influence the decision, but the important principle here is that just because the NPV of a long-term asset is negative, it doesn’t necessarily mean you should sell it immediately.
Sourse:
Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myer