The Real Options Approach To Investment Decision Making.

1604 words - 6 pages

1. Real OptionsReal-options analysis is one of the most important ideas of applied corporate finance to be developed in the last 30 years. Real-options analysis gives management the flexibility to address uncertainties, as they're resolved. Conventional capital budgeting fails to account for this flexibility and, moreover, fails to integrate strategic planning. But the real-options methodology goes beyond a simple view of valuation and more closely matches the manner in which businesses operate. Once a project begins, a manager has the choice to defer additional work, abandon it outright, shut it down and restart later, expand it, trim it back, or even switch its strategic purpose.The real-options method has been used in industries like natural resources, energy, and pharmaceuticals, which have a higher degree of uncertainty in business-process investments. For example, in the oil-drilling industry, uncertainties include issues such as what the cost of the leased land will be. How large are the oil reserves? What is the proper price for the lease on the reserve? Questions like these have led to the use of the real-options methodology as an analytical tool to evaluate these investments in business technology.Real options offer another valuable comparison with financial investing: that holding a diverse portfolio of stocks is less risky than owning one stock. Applying this view of offsetting risk to asset/project evaluation allows for the integration of capital budgeting issues with physical assets on the one hand, and the incorporation of decision-tree analysis on the other. Real assets can be evaluated using techniques developed for financial options, such as the Black and Scholes model.2. NPV MethodThe Net Present Value (NPV) has been one of the most common methods used in making investment appraisals. Most financial managers are familiar with the NPV method, which is based on expected cash flows projected over time that are then discounted at the weighted average cost of capital. It is a standard practice to approve projects with positive NPV and reject the projects with value less than zero. The fact that the NPV method only looks at cash flows is its biggest asset and its biggest drawback. The NPV method was flawed even before it was compared to the Real Options method. In the 70's, financial managers who accepted projects at NPV>0 noticed that NPV produced errors, as the approved projects later turned sour. The problem with NPV was, some projects with positive NPV could not be able to generate enough cash to meet the initial investment. However managers learnt from their mistakes and decided to accept projects withNPV = Investment (where present value of future cash flowsshould exceed initial investment)3. Real Options and NPV in practiceNPV fails to model and fails to capture the value of flexibility. The situations where there is a big difference between the two are all situations where the NPV is low relative to the value of the...

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