Real Options Analysis Term Paper

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Real Options Analysis

Companies resort to capital budgeting in the process of taking decisions with regard to making long-term investments. The projects involving capital budgeting are chosen by the companies in terms of expected generation of cash flows. Since profitability is the main criterion for long-term investments of the companies the strategic decisions with regard to the long-term investments involves a cost-benefit analysis in terms of cost of investments and expected generation of cash flows over the period of time. Emphasis is being laid on the concepts of Net Present Value and Internal Rate of Return etc. To assess the benefits of long-term investments against the cost of capital invested. The cost of capital of a firm signifies towards the cost of obtaining of capital by the firm that is used for long-term investments. Generally the firms define economic profit as the operating profit excluding the tax and cost of capital.

The terminology, Economic Value Added is also used to mean the economic profit. A positive economic profit indicates greater returns of the company over the cost of capital. In order that the company operates with a real profit it should be ensured that the returns are more than the cost of capital conversely it leads to loss. The long-term investments are associated with uncertainty, and therefore necessitate firm decision making techniques analyzing and estimating the probability of outcomes taking and the values of these expected outcomes. Even though the firm managers try to put all their efforts for reducing risk taking assistance of the best possible information available, the uncertainty of weather and markets cannot be avoided. This makes essential the firms to depend upon the various decision making techniques while making strategic long-term investments. [Budgeting and decision-making techniques]

The choice among the investment opportunities are made by the managers using different techniques for valuing the opportunities. Presently four different techniques are available with the managers in order to value the investment opportunities they are payback rules, accounting rate of return, net present values and real options. The technique of payback rules indicates the assessment by the managers of the minimum period that the firm requires in order making the cumulative cash flow of the asset greater than the cost of capital invested. The project is approved only if the period so estimated is less than the benchmark period of the firm. This technique does not take into consideration the expected cash flows that the asset generates beyond such periods. Managers are not concerned about the positive or negative cash flows in subsequent periods. [Using real options in strategic decision]

The accounting rate of return normally depends upon the average returns of profit over period of time that the asset accrues through out its life excluding the depreciation and tax involved during the period. The accounting rate of return is calculated in terms of the ratio of such returns to the average cost of capital. The project is approved if accounts for the profitable over the period of time. These methods are resorted to commonly for its simplicity of calculation involving easy forecasting of the cash flows in near future. Since the data relating to the accounting rates of return are maintained in the firm as a routine matter, the comparison of data and its monitoring is comparatively easier. Estimation of the expected future cash flows and determination of an appropriate discount rate is necessitated for calculation of the Net Present Value of the investment. The Net Present Value approach is based on the principle of capital budgeting that involves subtraction of the present value of cash inflow from the present value of the cash outflows. The Net Present Value involves comparison of the present value of every dollar invested with that of the returns that the dollar fetches taking into consideration the rate of inflation and rate of return in to account. [Using real options in strategic decision]

The approval of the long-term project necessitates a positive Net Present Value and alternatively, a negative Net Present Value rejects the proposal since it indicates the negative returns in terms of negative cash flows. Initially, the Net Present Value technique was developed to assess the future flow of investment in bonds. The investors in bonds are said to passive since they have no control over the alteration of the coupons that they receive, the future cash flow and the principal paid or on the rate of return after discount at an appropriate rate. On the other hand the Companies are not passive investors and armed with the liberty of selling the assets, expansion of the asset with further investments and also total abandonment of the projects which leads to the uncertainness and flexibility. The real option analysis is a tool developed more recently to cope with these types of uncertainties. [Using real options in strategic decision]

Attainment of the highest economic value is prime objective of the sophisticated capital budgeting of the firm. The traditional techniques evolved in this direction are the technique of Discounted Cash Flow Analysis that involves a combination of the techniques such as Net Present Value, Internal Rate of Return and Profitability Index. The approach of Discounted Cash Flow analysis takes into consideration the opportunity cost of the invested capital by the capitalists before making strategic decisions of long-term investment. Thus the Discounted Cash Flow technique involves discounting of the future cash flows in order to calculate the Net Present Value of the project. The Net Present Value of the project is determined in terms of the expected impact of the project on the value of the firm. The Net Present Value of the project is calculated in terms of the present value of the cash inflows of the project after subtraction of the cash out flows.

The Net Present Value is expressed in terms of the formula: Where NPV implies Net Present Value, E (Ct) indicates the expected value of the forecasted incremental cash flows at time t, T indicates period of time over which the project is expected generate economic value and r representing the opportunity cost of capital, which is calculated as expected rate of return on securities that is equilibrated with the equivalent amount of risk involved in the projects. The calculations of the net present value can be exemplified as follows: Suppose the cost of house is $50,000 and it becomes necessary to sell of 50000 shares of stocks each piece costing $1 in order to raise the entire capital. Assuming that A purchased 15000 shares, B purchased 15000 and the owner purchased remaining 20000 shares, the calculation of the Net Present Value of the shares, upon the sale of house at $60,000 involves calculations as share of A = $18,000 (=15000/5000 x $60,000), share of B = $18,000 and share of the owner is $24,000. [The Role of Strategic Thinking in the Analysis of Hard Investment Evaluation Problems][Net Present Value and Other Investment Criteria]

The Net in the Net Present Value signifies subtraction of initial project cost after calculations of the Present Value of the projects inflows. Thus the Net Project Value cannot be equated to the Present Value but be calculated as the remaining amount after setting apart the Present Value of the outflows from the present value of the inflows. The Discounted Cash Flow valuation involves estimation of the market value of assets and their benefits by taking into consideration the future cash flows that the asset generates. Following the methods of Discounted Cash Flow analysis an investment project with positive Net Present Value is approved while negative Net Present Value of the project favors its rejection. Pack back period rule is another criterion in Discounted Cash Flow Technique. The pay back period indicates the length of time that is required in order to make the accumulated cash flows equal or exceed to the capital investments made originally. [The Role of Strategic Thinking in the Analysis of Hard Investment Evaluation Problems][Net Present Value and Other Investment Criteria]

In making strategic investment decisions, only the projects among all the similar mutually exclusive projects, that is estimated to return the initial investments in less period of time is considered as better projects and selected for approval. The advantages of this rule stems from the fact that it is simple to understand, it is said to have adjusted for uncertainty of later cash flow, and it seems to have biased towards liquidity. However, it is criticized on the ground that it does not taken into account the time value of the money, it does not taken in to consideration the future flow of cash after the payback period while assessing the viability of the project and it is said to be biased against long-term projects. The Average Accounting Return is calculated as the measure of accounting profit divided by the measure of average accounting value in other words it is defined as Average Net Income/Average book value. [The Role of Strategic Thinking in the Analysis of Hard Investment Evaluation Problems][Net Present…[continue]

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