Real options analysis in strategic decision making

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 Value and Other Investment Criteria]

The project is approved using this technique only when the Average Accounting Return is estimated to exceed the target return. The weaknesses of this approach lies in the fact that it is not capable of comparisons with the returns in capital market due to its involvement in accounting figures rather than cash flows. Moreover, it assumes most impracticably the value of the money to remain constant throughout. Besides it has been observed that there is no objective way in order to determine the cut off rate. The Internal Rate of Return indicates the minimum rate of return over the period of time that results in the future cash flows in terms of the present value of money equals to the initial cost or investment. According to the Internal Rate of Return approach the project is considered to be viable when its Internal Rate of Return is expected to exceed the required return. [The Role of Strategic Thinking in the Analysis of Hard Investment Evaluation Problems][Net Present Value and Other Investment Criteria]

In case of the projects involving conventional cash flows that involves initial payment of costs and attainment of benefits over the life period and when the projects are independent so that its acceptance or rejection does not affect the other projects it is seen that the decisions made employing both the techniques of Net Present Value and Internal Rate of Return results in similar conclusions for rejection or acceptance. The Internal Rate of Return is adjudged to be the borrowing rate in case of non-conventional cash flows when the cash flows are of loan in nature that implies input of money at the first instance and the out flows at a later stage and in this case the lower the rate is better for the project to be viable. The profitability index of the project is calculated on the basis of cost benefit analysis and expressed as the future cash flows in terms of the present value of the money divided by the cost of initial investment. [The Role of Strategic Thinking in the Analysis of Hard Investment Evaluation Problems][Net Present Value and Other Investment Criteria]

The Profitability index depends upon the Net Present Value of the project, and as it is observed the profitability index is greater than one when the Net Present Value is positive. The projects with less than one profitability index are rejected. Thus the Discounted Cash Flow method involves the prediction of future cash flows after discounts made at the risk adjusted rate that equals to the opportunity cost attached to the Capital. However it has been observed that the estimation of the opportunity cost taken into account only the market prices risk and ignores the private risk involved. To overcome this weakness some times it is customary to use Weighted Average Cost of Capital of the company. However, this is not accurate since it involves the risk factors attached to the whole company rather than to the particular investment. This creates it problematic to arrive at an accurate discount rate for evaluation of the future cash flows. Besides, objections against Discounted Cash Flow method are leveled on the ground that the method assumes only a low market uncertainty. The calculation of the future prospects is based only on the available current information ignoring the possibility for altering the decisions in the future. At the circumstances of high uncertainty and flexibility the efficacy of the use of Discounted Cash Flow method is therefore, under question. [The Role of Strategic Thinking in the Analysis of Hard Investment Evaluation Problems][Net Present Value and Other Investment Criteria]

The Real Option Valuation technique is used with advantages as an alternative over the discounted cash flow technique. The Real Option Valuation technique involves prediction of the returns with an assumption that the asset valuation is closely connected to the management of assets. There exists in this connection a difference between financial assets and real assets of the company. The future value of the real assets of the company depends upon the ability of the company for dynamic and effective management of the asset over the period of time. The managerial flexibility corporate synergies, risk of share holders etc. thus are taken into account in order to have a more accurate valuation of the assets. [Dream Tree and ROV help to make investment decisions]

Acquiring offshore lease by an oil exploration company for instance involves cost of an option, which confers the company with the right but not obligation to develop the project. The cost of developing the project constitutes the exercise price of the option. Thus the real option is associated with management control of the options attached to the asset with simultaneous ownership of the underlying assets. The valuation of real options involves complex processes and necessities visualizations of the facts of when and how that the options are exercised. The real option valuation thus takes into account the strategic value of the assets by assigning values to all of the options available to the management. [Dream Tree and ROV help to make investment decisions]

The concept on l options pricing was conceived in 1973 by Black and Scholes and latter developed by Myers. For their achievements Scholes and Merton were awarded the Nobel Prize. The real options are an extension of the options concept to the real assets attempted by Myers. The Real Options technique lays emphasis on the value of the flexibility of the management while making decisions during the operation of the project. The Real Option technique thus integrates the flexibility of the management in terms of options to include, defer, abandon, shutdown and restart, expand, contract, switch use etc. with the strategic planning. As per the European Option a call option confers the owner with the right to buy while a put option the right to sell the underlying asset at a fixed date. As per the American Option the call option and put option envisages right to buy and sell an asset at any time up to a fixed date at the striking price. [Real Options and Strategic Decision-Making]