Other Considerations in Capital Budgeting

Other Considerations in Capital Budgeting

The real option creates economic value by generating future decision rights for management.

Learning Objectives

Describe how options influence capital budgeting and investment decisions

Key Takeaways

Key Points

  • Traditional NPV analysis fails to consider that management can adapt and revise its strategies in response to unexpected market and technological developments that cause cash flows to deviate from their original expectations.
  • The notion of real options was developed from the idea that one can view firms’ discretionary investment opportunities as a call option on real assets, in much the same way as a financial call option provides decision rights on financial assets.
  • The option to defer an investment creates value because exogenous uncertainty can be reduced with the passage of time.
  • Growth options are investments made not only for immediate cash flows from the project, but also for the economic value derived from subsequent investment opportunities.

Key Terms

  • net present value: the present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision
  • propensity: A tendency, preference, or attraction.

Real Options and Capital Budgeting

Traditional capital budgeting theory holds that investments should be made when the simple net present value (NPV) of an investment opportunity equals or exceeds zero. It also assumes that the investment must be made either now or never. However, such an investment approach fails to consider that management can adapt and revise its strategies in response to unexpected market and technological developments that cause cash flows to deviate from their original expectations. In other words, it fails to capture managers’ flexibility in adapting their decisions to evolving market and technological uncertainty. The notion of real options was developed from the idea that one can view firms’ discretionary investment opportunities as a call option on real assets, in much the same way as a financial call option provides decision rights on financial assets.

A simple financial option gives its holder the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a specified price at or before a specified date. By analogy, a real option confers on the firm the right, but not the obligation, to take some action in the future. The option is “real” because the underlying assets are usually physical and human assets rather than financial securities. The commonality in applying option-pricing models for real assets and for financial securities is that the future is uncertain. In an uncertain environment, having the flexibility to decide what to do after some of that uncertainty is resolved has value. A key feature is that the real option creates economic value by generating future decision rights – specifically, by offering management the flexibility to act upon new information such that the upside economic potential is retained while the downside losses are contained.

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Project Cash Flow With Uncertainty: Projects with real options can be evaluated using a range of possible profits.

Real Options and Investment Decisions

A strategic implication of real options theory is that investment will be discouraged by exogenous uncertainty. For this reason, the timing of an investment can be crucial in determining its profitability. In other words, the option to defer an investment creates value because exogenous uncertainty can be reduced with the passage of time.

Another value-creating aspect of real options can be found in abandonment. The abandonment options comes into play when a firm purchases an asset that it may later resell or put to an alternative use, should future conditions be sufficiently adverse. Availability and recognition of this option will increase a firm’s propensity to invest relative to what would be suggested by a simple NPV rule, which assumes that the investment project continues for its physical lifetime and omits the possibility of future divestment.

Growth Options

Real investments are often made not only for immediate cash flows from the project, but also for the economic value derived from subsequent investment opportunities. Such future discretionary investment opportunities are known as growth options. For example, firms usually undertake research and development investments to strategically position themselves for the economic value from commercialization when market conditions turn favorable. Similarly, firms usually make foothold investments in a new foreign market for the possibility of expansion in the future. Such growth-oriented investment may appear uneconomical when viewed in isolation but may enable firms to capture future growth opportunities.