Real Options Method in Capital Budgeting

Real options method is one of the investment appraisal techniques for capital budgeting which can deal with the limitations of the Net Present Value (NPV) method. Real options method is a method of evaluating and managing strategic investments decisions in an uncertain business environment. Using real option methods has been recognized that the application of standard NPV techniques can lead to wrong conclusions in the presence of unrecognized embedded options. The central role of NPV techniques in financial decision making therefore makes it imperative that real option structures in investing opportunities are identified and accounted for. It turns out that real options can be found in most live environments where uncertainty or risk, waiting, investment irreversibility, growth opportunity, asymmetric information, staged investments, competitor response, economies of scale, project switching, suspension, abandonment and start-up are important. In fact, these include the full spectrum of investment decision making, including those concerning capital budgeting and the fact that the standard NPV techniques do not recognize or deal with these situations adequately.

Real options methods are introduced in order to correct the problems of NPV method. This method calculates the value of an investment with techniques originally developed for valuation of financial options which gives possibility to take into consideration the managerial flexibility to take action during the lifetime of an investment.

Real options method is a controlled means of systematically identifying the interplay between intermediate outcome states and alternative managerial actions and specifically valuing managerial flexibility. The capital budgeting decisions often involve investment, capital assets and most decisions can be viewed as options on real assets.

Approaches of Real Options Method

There have several approaches to real options method such as process approach, re-evaluation of NPV and framework approach.

1. Process Approach

Real options method can be interpreted in a process view besides using calculation method. Real options analysis may not be project valuation, or quantifiability, but the process of describing and understanding the project and the uncertainty embedded therein. The real option method for capital budgeting emphasizes on ongoing learning about the risks and potentials of a new venture over time. Ongoing evaluation effort is influenced by changes in the business environment. It is a process in which the valuation even the computing process, is not intended to provide a sure answer, rather to provide decision makers an ongoing dialogue about the project/investment. Therefore, it is necessary to has a process view of real option approach in analyzing the decision support needs. There have four main stages of continuous of process taken when adopting real options valuation:

  1. 1st stage – Identifying options (the possibilities on internal and external of a project) in light of newly available information and updating the decision tree at different project stages.
  2. 2nd stage – Evaluating the options: quantitative and qualitative analysis of the value of the options.
  3. 3rd stage – Selecting the important options: ranking of or voting for real options based on the valuation.
  4. 4th stage – Execute the options if optimal, advancing in the decision tree.

In order to proceed the process requires several things such as up-to-date project status information readily available to decision makers; up-to-date market information and industry foresight (future events or trends) constantly made aware to decision makers and be integrated into various phases of real options valuation process. The process requires option analysis and evaluation to be done periodically and applying advanced option valuation methods. In order to able to carry out the process efficiently and effectively, the managers who responsible for a project need to be aware of the current situation of the project. Information about the project need to be obtained continuously by interpreting a process of following the large changes in the environment of the project such as shifts in the markets, etc.

2. Re-evaluation of NPV Approach

Real options method applied to re-evaluate the traditional capital budgeting technique, NPV. When real options are an appropriate appraisal technique, important points of principle may need re-evaluating. The true value of an investment is given by: Expanded NPV = Passive NPV + Real option value. The fact that options mostly have positive values indicate that traditional NPV(passive) rejects too many opportunities without consider the value of flexibility. It is important to realize that the addition of real option values in such a framework is inappropriate, unlike straightforward NPV additions, because of the interactivity of option values. For instance, abandonment of a project midstream rules out subsequent option values that would have arisen had the alternative been to continue with the project. Second order interactions may arise should a real option be exercised (i.e. when the project is undertaken), as the scale of operations may be increased so that the values of other real options which are dependent on capacity will be increased. In conclusion is that ignore strategic or operating flexibility will lead to misjudgement on investment opportunities.

There have few important criteria needed to take note when valuing real options method. The criteria such as investments can be deferred; investment exposed to risk; and high interest rates.

  1. Investments can be deferred – The possibility of deferring an investment facilitates evaluation of future events when they arise and avoids costly errors. Furthermore, deferring investments improved the investment timing from traditional NPV approach to one which recognizes the strategic benefits of waiting.
  2. Investment is exposed to risk – “No risk, no gain”, as for each investment needs to face risks in order to gain a satisfactory returns. Investments need risk to offer a sufficient return to shareholders beyond the risk-free rate and the real options have greater value in the face of risk. The real options method often undertaken to evaluate risks, if a project timings and outcomes can be manipulated to take advantage of the risk potential which in return will gain financial benefits from them.
  3. Interest rates are relatively high – With higher interest rates or discount rates, it cause the future value of particular capital to be lower compared to current-day capital’s value. Higher discount rates mean that the future capital necessary exercise a real option (undertaking a further contingent part of the project at some future date) is lower in present-day terms. Therefore, financing a new project may be done in stages where staged investments offer the opportunity of expanding the number of exit routes while lowering the present value of cash outflows.

3. Framework Approach – Fuzzy Capital Budgeting

Fuzzy capital budgeting is to use fuzzy versions of the traditional capital budgeting methods and real option valuation. It needs to be observed that the fuzzy versions of the methods are original constructions, and not fuzzifications of the existing methods which means that the mathematics is that of possibility instead of probability. To elaborate on what fuzzy mathematics can add to capital budgeting, the first thing to consider is about how efficient way of a manager to think about future cash flow estimates of a project, for example, the manager estimates that the project will produce a cash flow between 30 and 40, in three years from present day. With fuzzy capital budgeting methods these estimates can be used, provided that they are the best available estimate of the future cash flow, without having to re-calculate them into one number which is done by other common approaches. It is known that the uncertainty is included in the estimate and carried directly into the profitability calculation where there is no loss of information, and the picture given is not out of expected.

Fuzzy numbers give a possibility to include qualitative information into capital budgeting process, in a straightforward way. The fuzzy sets presenting the cash flow estimates can be adjusted dynamically to reflect the future trends that are revealed by a foresight process, and are in a qualitative form. Real options and fuzzy capital budgeting open the chance to explore the value of flexibility inside and outside of a project, and give further details into uncertainty of large investment.

Benefits of Real Options Method

Real option method recognizes the incremental value arising from flexibility which gives rise to additional value is recognition of the altered probability distribution of potential outcomes and its impact on risk exposure. And, also using real option methods can deal with risk in capital budgeting correctly.

Real options provide a useful framework for strategic decision making and deal with uncertainty and flexibility efficiently. Real option method is a helpful tool to give insight into the value of the possibilities that can be found by investing in a given investment.

Real option valuation widens the managerial horizon to take into consideration and consider the possibilities of an investment. Real option valuation used to find the optimal time of investment and to take the managerial flexibility to act in consideration in an intuitive and correct way.

Real options method can value asymmetric payoffs which can provide a means of valuing managerial flexibility – the ability of managers to intervene proactively to take action during the time frame when the results of previous decisions are being played out. Real options analysis able to reformulate the problem resulting in more insight into the project and the potential sources of value.

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