Net present value and real options in investment decision-making

¶ … Financial Management

Required: I

Net Present Value (NPV) is a financial technique used in capital budgeting to evaluate the profitability of a project. To determine the viability of investment, it is critical to invest when NPV is positive or greater than zero. Organizations face option to move forward with the investment or to abandon an investment. When an NPV is greater than zero, the investment should be accepted. The decision tree is very critical in the investment analysis. Using NPV could assist in making right investment decision. From fig 1, John could only accept the investment since it is revealed that NPV of an investment is more than 1 which is profitable. However, when the profit is $0. It will not be possible for John to pursue the investment

Fig 1: Decision Tree

Profits

$1,000-$500=$500

In the contemporary business environment, investor should consider volatility of stock before making an investment decision. Typically, the variable behind calculating fair value of stock option is the volatility, and volatility has largest effect on stock price. Typically, the percentage change in stock price is normally being affected by the volatility of the stock price. Volatility of stock measures the uncertainty about the return that stocks will yield. Although, it is essential to pursue with the investment decision when NPV is positive, however, when there is high degree of volatility in the economy, it is better to wait before implementing an investment even when NPV is positive. It should be noted that volatility of the stock is out of control of decision maker. However, using Black-Scholes Model, it is advisable to implement short-term investment under volatility period when NPV is positive.

Moreover, "in the absence of dividends, it is not to exercise call earlier. In the real option context, it is always better to wait unless there is a cost of doing so. The greater the costs, the less attractive, the less attractive the options to delay become." (Hillier, Ross. Westerfield, and Jaffe, 2005). However, the interest rate is the critical factor that determines call premiums. The increase in the interest rates will increase the call premiums which will make the premium to decrease. To understand the effect of interest rates, it needs to compare option position to owing a stock. On the other hand, cash dividends option prices have significant effect on the underlying stock price. The stock price is expected to drop by the amount of dividends at ex-dividend rate. Dividends are very critical when exercise a stock call option. The call options are very critical when determining the cash dividend. Investment decision is based on the whether an investment stands to yield positive NPV. (Brealey, Myers, and Allen 2008).

To value a project; it is necessary to estimate the discount cash flow to determine the opportunity of highest value of a project as being measured by NPV. Given uncertainty inherent in the investment due to volatility, it is essential to assess the sensitivity of an investment using NPV. (Hillier, Ross, Westerfield, and Jaffe, (2005)

Required: II

Using the Black-Scholes Model it is appropriate to start the project today and not to wait for one year before starting the project. To invest today or wait for one year before starting the project, it is essential to invest when NPV is substantially greater than zero. It is critical to invest today if the NPV of today is greater than NPV of waiting. For example, an investment that currently has negative NPV should wait until the NPV is positive. If the NPV is positive today it is better to invest today rather than wait till next year because an investment with positive NPV today is likely to generate positive free cash flow. In the real world, there is always a price to pay by delaying an investment decision. Thus, it is better to invest today if the NPV is positive and exceed the option of waiting. When there is high degree of uncertainty due to volatility, it is better to wait before implementing an investment.

Based on the application of the Black-Scholes model in the present day financial analysis, short-term investment analysis could only be valued using Black-Scholes model because volatility could change at very rapid rate within few days. Typically, Black-Scholes model is not too applicable for medium term or long-term option. As being argued by the Black-Scholes model, hedge is the key behind the derivation where option of buying and selling the underlying asset right away is very critical to eliminate the investment risks. The model calls the hedge the delta hedging which is the basis of complicated hedging strategies. Typically, Black-Scholes require an investor to make investment decision right away to eliminate investment risks in order reduce the risks of price volatility. Black-Scholes Model reveals a mathematical model in the capital market, which reveals the derivative investment instrument. Black-Scholes deduces the formula that gives the price the European-style option. The model is widely used by option market participants.

The assumptions of Black-Scholes Model are as follows:

There is no way an investor can make riskless profits because there is no arbitrage opportunity.

It is possible to lend and borrow cash at constant risk-interest rate

It is possible to buy and sell any amount of stock and this includes the short selling.

The above transaction is frictionless market where transactions do not incur paying fees.

The stock price follows constant volatility with geometric Brownian motion

It is not necessary to pay dividends in the underlying security.

Hedging position is possible with the assumption of Black-Scholes Model.

Although, the model could be applicable in the real world situation however volatility is not constant in real world situation.

Required III

The Black-Scholes is a mathematical model that follows the stochastic process to calculate the value of stock option and pricing equity option. The basic principle behind the model is that the price of an option is being determined by the price of the underlying stock. According to Black-Scholes model, the price of a stock is t-1 and is independent of price in time t, which is referred to random walk.

The Black-Scholes formula consist of three parts:

First part

The above formula is used to calculate the option values. The part tells the price of European-style call option. The T. And S. are equal to the price of the stock that could be adjusted to interest rates, volatility, and spread.

Second Part

PART B

Adjusted Present Value (APV) is a financial instrument to determine the worth of an investment. APV is used as a business valuation method, and it determines the potential profitability of a project by using cash flow technique. The NPV compares present cash inflow of a project with the present amount of cash outflow to determine the project profitability. Thus, APV is the sum its NPV to all equity as being revealed below:

APV = "NPV (unlevered project) + NPV (financing decisions)"

Separating APV of a project into its Net Present Value (NPV) enhance financial decision of a finance manager.

There are various advantages of APV associated with investment decision.

First, APV is advantageous because it could value a project as if the project is entirely financed with equity. Typically, APV is a financial tool to value all financial side effects such as:

Costs of Financial distress

Interest rate tax shields

Subsidies & guarantees

Issuance costs

Hedges

APV is also effective when considering the case leverage buyout especially if the company is loaded with high amount of debt. NPV is advantageous because it is able to account for tax shield benefit when considering interest in the cash flows. For exa mple, NPV is effective for discount tax shield using fixed debt assumption, and using zero-level WACC.

In addition, APV is suitable for the valuation when the debt to equity ratio is volatile and changing significantly. APV can also handle the side effects of the issue such as issue costs, tax shield and bankruptcy costs. NPV is also beneficial to financial distress costs which could be used to assess the profitability of bankruptcy as well as estimating cost of bankruptcy.

Essentially, issuance costs are critical when raising equity. Issuance costs such as commission, discounts, fees and underwriting. APV take into account of these costs when evaluating separate projects.

Unlike other valuation technique, APV is principally valuable as follows:

To serve as a check against other discount cash flow valuation methods.

Effective when there are changing in the debt structures.

To optimize debts level

Valuation of financing of a project.

Net Present Value (NPV) is also a valuable financial tool for the valuation of a project. However, APV has advantages over NPV because APV can be used to estimate cost of bankruptcy, and profitability of bankruptcy. Moreover, APV could be used to value highly transaction LBO and NPV could not. APV. In addition, APV is suitable for the valuation when the debt to equity ratio is volatile and changing significantly and NPV is not effective to carry out this task. (Brigham, Houston, 2011).

List of References

Bodie, Zvi; Alex Kane, Alan J. Marcus (2008). Investments (7th ed.). New York: McGraw-Hill/Irwin.

Brigham, E.G. Houston, J.F (2011). Fundamentals of financial management. Cengage Learning, UK.

Brealey, R., Myers, S., and Allen, F. (2008) Principles of Corporate Finance, 9th edition, McGraw-Hill.

Hillier, D., Ross, S., Westerfield, R., and Jaffe, J. (2005) Corporate Finance, 7th edition, McGraw-Hill.

MacKenzie, Donald; Yuval Millo (2003). "Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange." American Journal of Sociology 109 (1):