1S3

Today's optionsfor tomorrow'sgrowth

Carl Kester

Companies can reduce theguesswork ofinvestment analysis byclearly linking

current capital budgetingdecisions withstrategic opportunities

At a recent managementconference, an upper-levelexecutive of a prosperoushigh-technology companywas asked to name hismost difficult problem.Instead of citing Japanesecompetition or the con-stant need in that businessto come up with innova-tive technology, the execu-tive stated simply, "tryingto convince my CEO andboard to approve an ideafor a new investmentproject."

Many managers will agreethat getting a projectthrough a corporate capitalappropriations committeecan be one of the most frus-trating and unrewardingexperiences of corporatelife. Battles wage against abackground of high inter-est rates, tight budgets, andincreasing sensitivity toinvestment risk. Typically,two sides develop; strate-gists, who look at a projectfor what it might accom-plish, are pitted againstquantitative analysts, wholook at it for what it willcost. Often the only resultis a stalemate.

In an attempt to bridge thegap between the two sides,Mr Kester offers a sugges-tion that gives a harder

analytic edge to the softside of the investmentargument. He suggests thatmanagers think of invest-ment opportunities asoptions on the company'sfuture growth. Like calloptions on securities,growth options representreal value to the compa-nies that possess them, andalmost any future invest-ment plan can be analyzedin those terms. He guidesthe reader through a dis-cussion of the rationalebehind this way of think-ing and of some of its prac-tical applications forcompanies.

Mr. Kester is assistant pro-fessor of finance at theHarvard Busine.'is School.Consulting and researchactivities have taken himinto the areas of capitalbudgeting, working capitalmanagement, financialgoal setting, valuation, andacquisition.

Since the rise in the use of discountedcash flow techniques, most managers face an increas-ingly difficult choice in evaluating complex invest-ment decisions. Should they pursue risky projects thatoffer a below-target rate of return but could createvaluahle strategic opportunities later? Or should theystick with a less risky and more immediately profit-ahle bet?

Whether it's a diversified company try-ing to keep pace in a fast-growing market or a smoke-stack company struggling to regain its competitiveedge, the choice must be made. Take the case of a large,technology-based company Despite a cut in spendingplans to avoid outside financing, the capital appropria-tions committee decided to consider a special projectthat would require a plant for the large-scale manufac-ture of a new, proprietary material that had been suc-cessfully produced in a pilot plant.

On an ordinary net present value hasis,high construction costs, low projected cash flows, anda high sensitivity to cyelical fluctuation combined tomake the project unattractive. Opponents argued itwould hurt reported earnings, diminish near-term cashflows, and depress an already low stock price.

Proponents pointed out the project'slong-term strategie benefits. Wide acceptance of thematerial would produce a virtual cascade of new com-mercial development and capacity expansion projects.The project's value came not so much from cash flowsdirectly attributable to the new plant as from opportu-nities for growth. In the end, the proponents prevailedby not falling back on the corporate culture. Theyrecalled a similar project the company had pursued justbefore World War Il-one on which much of its postwarsuccess was built.

The committee finally approved theproject but, because of uncertainty and the lack ofstronger analytic support, it deferred final appropria-tion for one year. Ultimately, the new material sue-

154 Harvard Business Review March-April 1984

Researchmethodology

Clinical data and impetus for this article came frommy involvement in field research on financial goalsand resource allocation conducted in 1979-80 byProfessors Gordon Donaidson and Jay Lorsch atthe Harvard Graduate School of Business Adminis-tration. Twelve Fortune "SOC'-size companies withvarying degrees of product market diversity and Jownership concentration were studied. I inter- ^viewed managers at each company ranging fromfinancial analyst to chairman of the board, includingthe chief executive officer, the chief financial officer,and the director ot planning (or an officer with moreor less equivalent responsibilities). I also revieweddocuments such as capital budgeting manuals,annual plans throughout the 1970s, and internalrecords of capital expenditure and performance byline of business. The result of this field researchwas an extensive clinical data base of corporatedocuments and interview transcripts, rich in practi-cal perspectives on corporate planning andresource allocation processes.

ceeded. Production efficiencies were achieved, useracceptance developed, and new applications proliferat-ed. But the initial delay proved costly A competitor'ssubstitute product gained an early foothold in the newmaterial's primary market, forcing the first companyto spend more money than originally planned.

How eould the project's proponentshave made their argument more convincing so thatfunds would have been committed at once? More tothe point, what if a manager doesn't have history toback up his argument; What analytic framework canbe used to give a hard edge to the "soft" strategic sideof the investment argument?

Based on my research into the invest-ment and capital budgeting deeisions of eompanies(see the first insert), I've concluded that one answer isto think of future investment opportunities as analo-gous to ordinary call options on securities.' Most man-agers are familiar with call options since they tradeactively on public exchanges and such options areoften an important part of a compensation package.

Securities options give the owner theright (as distinct from an ohligation) to buy a securityat a fixed, predetermined price [called the exerciseprice) on or before some fixed date (the maturity date).By way of analogy, a discretionary opportunity toinvest capital in productive assets like plant, equip-ment, and hrand names at some future point in time islike a call option on real assets, or a "growth option."The cost of the investment represents the option'sexercise price. The value of the option (its underlying"seeurity") is the present value of expeeted cash flowsplus the value of any new growth opportunities

expected through ownership and employment of theassets. The time to maturity is the amount of timeavailable before the opportunity disappears.

Like call options on securities, growthoptions represent real value to those companies fortu-nate enough to possess them. Any investment projectwhose implementation can be deferred, that can bemodified by the company, or that creates new invest-ment opportunities can be analyzed using this frame-work. This would include opportunities to;

n Expand capacity, make new productintroductions, or acquire other companies.

D Increase budgets for advertising, basicresearch, and commercial development programs (in-sofar as these budgets represent investment in assetslike brand names or technical expertise).

n Make outlays for maintenance andreplacement projects (since these too are discretionaryprojects that can be forgone if management decides toshrink or leave a business).

Just as securities traders would price abond-warrant unit to reflect both of its sources ofvalue-that is, the cash from the bond and the optionvalue from the attached warrant-so too should a com-pany analyze an investment in such a way as to delin-eate all its sources of value.

The importance of growth optionscan be recognized by looking at the difference betweenthe total market value of a company's equity and thecapitalized value of its current earnings stream (seeExhibit I]. The difference is an estimate of the value ofits growth options. As the last column indicates,valuable growth options constitute well over half themarket value of many companies' equity.

While only large, publicly traded com-panies are represented in this exhibit, small, pri-vately held organizations share similar characteristics.In fact, growth options probably dominate the equityvalue of small, high-growth companies marketinginnovative products. The plethora of companies mak-ing initial public offerings at high price-eamings multi-ples attests to this fact. Genentech went public withannual revenues of $9 million and an operating cashflow of only 6(t per share. At the initial public offeringof $35 (a level quiekly surpassed in the immediateaftermarket), the market value of its equity was $262million- almost entirely based on options for futuregrowth, not on the attractions of its current cash flow.

1 This analogy was first drawn byStewarl Myers in

"Determinants of Corporate Borrowing,"lournal of Financial Economics, no. 5lRochester,NY:University of Rochester,19771, p. 147,

Options for growth 155

Exhibit I Growth option value as a component ofselected companies' total equity value

Market valueofeouity*S millions

Anticipatedeamings*$ millions

Eloctronlcs

Computersand peripheral

AppleComputer

DigitalEquipment

ConsolidatedFoods

General Foods

2,000

5,690

1,190

2,280

Capitalized value ot earnings using variousdiscount rates'*S millions

Estimated valueof growth optionst$ millions

15% 20% 25%

99

285

171

317

660 495 396 1,340- 1,604

1.900 1.425 1,140 3,790- 4,550

1,140 855 684 50- 506

2.113 1.585 1.268 167- 1,012

•Sourca:Value Une Investment Survey,Augusl 12,19B3.

••Anticipated earnings are treatedas a perpetuity

i Ranges of growth option value aredetermineiJ by subtracting thehigti and low values of capitalized earningsIroni the market value of the equity.

Percent o f ' _market valuerepresentedby growthoptions

Motorola

Genrad

RCA

$ 5,250

550

2,200

$ 210

17

240

$ 1,400

113

1,600

$ 1.050

85

1,200

$ 840

68

960

$ 3,850-

437-

600-

4,410

482

1,240

73-84 %

79-88

27-56

67-80

67-80IBM

Chemicals

Celanese

Monsanto

Union Carbide

TirMandrubbm-

Rrestone

Goodyear

Uniroyal

Foodprocasslng

Carnation

72.890

1,010

4,260

4.350

1,090

2,520

400

1.790

5,465

78

410

280

88

300

47

205

36,433

520

2,733

1,867

587

2,000

313

1,367

27.325

390

2,050

1.400

440

1,500

235

1.025

21.860

312

1,640

1,120

352

1.200

188

820

36,457-51,030

490- 698

1,527- 2,620

2,483- 3,230

503- 738

520- 1,320

87- 212

423- 970

50-70

49-69

36-62

57-74

446-68

21-52

22-53

24-54

4-43

7-44

Strategic capitalbudgeting

While some strategically importantinvestments allow for straightforward evaluationusing ordinary discounted cash flow (DCF) techniques(for example, a cost-reduction project for a companywhose competitive advantage rests exclusively onheing the low-cost producer), others seem to defy suchanalysis. This is true because they are but the first linkin a long chain of subsequent investment decisions.Future events often make it desirable to modify an ini-tial project by expanding it or introducing a new pro-

duction technology at some later date. Other spin-offopportunities such as the conversion of by-products tousable goods or the development of complementaryproducts to fill out a line may also arise.

Precisely how and when subsequentinvestment decisions will be made depend on futureevents. But the array-andattractiveness-of futureinvestment opportunities at the company's disposaldepends critically on the assets put in place in thepresent.

Realizing the importance of strategicinvestments and the difficulty of using quantitativetechniques to analyze them, companies have devel-oped a number of other methods of evaluation. Unfor-

156 Harvard Business Review March-April 1984

tunatcly, none has proved totally successful in practice.(Fur a runduwn ot the current methodology for analyz-ing investments, see the second insert.)

In fact, existing cures for quantitativeshortcomings may he worse than the disease. What isneeded in their plaee is an approach that overcomesboth the restrietiveness of ordinary net present value(NPV) analysis and the lack of analytic discipline thatcharacterizes qualitative evaluation.

Take the opening case example. Propo-nents of production of the new material understoodthe value of the opportunity hut could not convinceskeptics without recalling a precedent. Lacking thatprecedent, their unstructured application of intuitionand judgment would not have overcome formal, quan-titative arguments.

The proponents should have organizedtheir arguments around the concept of growth options.They could have argued more effectively that:

Discounted cash flow analysis under-states the value of the project.

The risk associated with the project wasone of the best reasons to preserve, notreject, it.

In an environment of high and risinginterest rates, the capital budget shouldhave been weighted in favor of suchprojects.

The options approach might havespared the company its subsequent mistake in delay-ing the capital commitment. In particular, it wouldhave enahled the committee to recognize those condi-tions under which it should implement the projectquickly and those under which it would be safe todefer.

How valuable are growthoptions?

The value of a call option on an assetdepends on the value of the asset itself and the cost ofexercising the option. If, for example, IBM's stocktraded at $ 120, a call option, giving its owner the rightto purchase a share of IBM at $ 100, would be worth atleast $20 and probably more.

The same logic applies to growthoptions. The opportunity to undertake a project isworth at least the present value of the project's cashinflow less the present value of its outflow. But the

opportunity to invest can be worth even more thanthe project's NPV How much more depends on:

The length of time the project can bedefened. Time is valuahle when deciding whetherto exercise an option. The ability to defer the deci-sion gives the decision maker time to examine thecourse of future events and the chance to avoid costlyerrors if unfavorable developments occur. It also pro-vides an interval during whieh a positive turn of eventscan make a project dramatically more profitable. Thelonger the interval, the more likely it is that this willhappen; hence, the longer a project can be deferred themore valuable a growth option will be.

Even a project with a negative NPVcan be a valuable "out-of-the-money" growth option ifthe eompany can put off the investment decision fora while. A company might maintain such out-of-the-money options even if they require ongoing spendingfor engineering, product development, market research,and so on, provided there is a realistie chance that fu-ture events will make the projeet more valuable.

Project risk. Paradoxically, risk is a posi-tive factor in the determination of a growth option'sworth. If two investment opportunities have identicalNPVs and can be deferred for the same amount oftime, the riskier of the two projects will be a more valu-able growth option. This is because of an asymmetrybetween potential upside gains and downside losseswhen an option matures. As Exhibit 11 illustrates, largegains are possible if a project's NPV increases. How-ever, losses can be cut by simply choosing not to exer-cise the option whenever the project's NPV is negative.This ability means that high risk increases the chanceof eventually realizing a large gain without equallyincreasing the chance of incurring a large loss.

The level of interest rates. High interestrates generally translate into higher discount rates andlower present values of future cash flows for any givenproject. Clearly, that should depress the value of anoption to undertake a project.

But higher discount rates also imply alower present value of the future capital necessary toexercise an option. Such a countervailing effect helpsto buoy the option's value as interest rates rise. Thiscan give certain kinds of projects - specifically, thosethat create new growth options-a crucial comparativeadvantage in tbe capital budgeting process.

How exclusive the owner's right is toexercise the option. Unlike call options securities,there are two types of growth options: proprietary andshared. Proprietary options provide highly valuable,exclusive rights of exercise. These result from patentsor the company's unique knowledge of a market or atechnology that competitors cannot duplicate.

Shared growth options are less valuable"collective" opportunities of the Industry, like the

158 Maruh-April 1984

their prctcrciict:-) UH\ ard projects that generate cashwhen Capital is ti^ht. But une large techuology-hasedcuiupaiiy dibeovcied J different kind of comparativeadvantage during a capital squeeze in the late 1970s.A meiiibei uf the eapita! appropriation committeedcsciibed tile puibkni:

"Allocatmg capital would be easy if youcould do U just 'by the numbers,' but you must etin-sidci 'dirc^tiunal' taciuis as well. The idea of a hurdle-rate [L.I evaluate projects] becomes even less importantinpcuodaof tight lapital because directional factorstake prfT.caenLL. When eapiial is tight, we take alongci naal viev\ u.id pick up the savings and eost-reduetion piujens l.itt.i."

llK.-.e "directional" factors are valuablegrowth optKjnb that the company looks for in new or

iUing when to exercise a growths uii a comparative analysis of the advan-

tages and dia.idvaut.igeb uf going ahead with a projectas huuii as i)tj.v->ible. Beeause this option to invest iswoi th more than the NPV of the underlying projeet, acompany .•>hotild wait until the last possible momentbetorc CumiiiUUngtunds. That preserves the option'spicrriiui'n while pioteeting the company from costlyand a\oni.inle liiKitakeb. A decision to commit funds toa piojtCt Liny earlui tluu neeessary sacrifices thisvalue.

Whtii to invest uarly

Experience shuws that companies oftencommit iiuestiaent fuiidb at a very early date despitetheir ahiluy to deter a final deeision- Companies thatdo su n'lusi believe that the cost of deferring the deci-sion cxeCcUs the value baeiifieed from early exereise.For instance, a eumpeiitur may preempt the move ortake dctiou that raiscb the cost of the project, as hap-pened to the coinpriny in the opening example. In gen-eral, a Loniprtiiy will find it pays to exereise its growthoptions caihcr than neces^aiy when: competitors haveaccess tcj the same opiiuii; the prujeet's net presentvalue ih higii, the le\el ut ri:!.k and interest rates aielow; and liiduiii y iivali y is intense.

Exhibit III shows huw a eompanyshould lime UK L^eii ise ot ltti growth options based onthe extent ot lndustiy rivalry and on the exclusivenessuf a conipJiny'h light to exeieise the options. The upperright and luwei kit quadraiiib offer straightforwarddireeauub tui i^uiiipanies. The other two present inter-mediate La Lii \\ ith less obvious results A companymay wish to exeicise even proprietary growth optiunsearly, fur cxan.ple, if the industry is intensely competi-tive uiida timely Luiiimitiaent is likely to discourageattaek.

A company geneially tiies to obtain adominant competitive position in oider to achieve andproteet hii^iietuiubun uivestnieiit But by givingacompany the ligiit to liijjt.' the liwebtnient more selec-tively, tbe growth option provides an important,though often overluuked, motive foi duminatiug themarket Uiie exceutive stated:

"What yuu'ie leally trying to do witheapital is create a siiung eumpeiitive position.... We say|to oui division uiaiiagers| 'Do what you have to do toretain a leadership position ui the shurt lun.' Uf course,over the lung i uu, yuu ^aii stay a leader unly if youhave the best cost pusuiun, su we must pay attentiontu that. But get the stiuugesi kadeiship pusitiuu, andthat IS what is j uiug tu pay ott.

"Ihe advantage ut being number one inan industry is theoppuitunity tu initiate changes inteehiiology and piieiug It UI\L initiates ehange, one isin a mueh better pusitiuii tu take advantage of itbeeause une eau, in efteet, euiuiul the timing and antic-ipate the outcome."

Using the fiamcwork

the deteimiiianls of a gruwthoption's value and the many difteient eharaeteristies itcan display, nu aiiigli.. tuimula ean embody its valuerehably Consequently, the tii:>t assessment of a projbctexpeeted tugeiieiate new ^uiwth upturns might best bequalitative, althuugh luuteU lu established principlesof option valuaiiuii.

As a fii.il step, the euiiipany should clas-sify proiects niuie ueeuialely aeeuiding to their giuwthoption ehaiaeteiisties. classitieatiun along tiaditioiialfunctional lines such as leplaeenient, eust leduetiun,capacity expansiuii, and new piuduet mtiuduetioiipiuvides little j^uidanee A liiuie appiupiiate elassifica-tiun begins by distm^aisllmg between prujeets whosefutuie benefits aie lealued piimaiily through Lashflows (simple uptiuiis) aud those vvhuse tutme benefitsinclude oppuuumtiea tfji turihei diseretiunary mvebt-meiit (eum[ntunduptiuiis|. Simple giuwth options-like luutiiie eust leduetiuii and mamteiiaiiee andreplaeelnent pio|eeis eieate value unly thiuugh thecashtlows stemming tiuni the undeilyiiig assets.

L.unipuund ^luwtli uptiuns - likeresearch and develupment piuje.-ts. a ma|ur expausiuiim an existing niaiket, eniiy mtua new market, andaequisitiuiis kad tu new nive.-^iment uppurtunitiesand atfeet the value ut eAi.iim^giuwih uptiuns.

A simple gruwih option requires onlythat the cumpany evaluate eash flows accurding to netpresent Viilue ur late ut retuiii metbuds. The complex-

Options for growth 157

The difficulty with

None of the quantitative techrfl^BS^^Ituted bylarge companies to help make investment deci-sions has proved completely adequate for han-dling the practical questions they raise. Thedifficulty with discounted cash flow techniques, forexample, is that future investment opportunitiesare discretionary. Trying to reflect their worth In aterminal value calculation, designed to capturecash flows beyond whatever horizon date is usedin a net present value analysis, is not a satisfac-tory solution because most companies substitutebook value, liquidation value, or treat the lastyear's cash flows as if they continued in perpetu-ity. Reliance on a market-to-book value multiple toarrive at a terminal value offers only a crude esti-mate at best.

Decision-tree analysis works in principle becausemanagers are forced to map out all future deci-sion points, contingencies, and probabilities.Although enlightening, decision-tree analysis canbe unwieldy and impossibly complicated forcompanies with even a modest number of proj-ects to consider.

Consequently, many companies have turned toother methods- for example, isolating and eval-uating strategically important projects qualitative-ly Such analysis rests heavily on the intuition andjudgment of key senior executives. Given the well-known tendency for 'hard" analysis to drive out"soft," the isolation of strategic projects is helpfulto the extent that valuable executive experienceis brought into play and truly important invest-ments are not routinely rejected by simplisticquantitative techniques.

But separate qualitative analysis may also com-promise the traditional corporate objective tomaximize the value of the company's equity. Thebreakdown of analytic discipline may result indecisions made on blind faith or by force of per-sonality, "Strategic" importance can become amuch-abused rationale for the acceptance ofweak projects. By separating strategic projectsfrom others, the company may foster the beliefthat investing to increase its stock price in theshort term is a different activity from investing togenerate growth - one of which must be sacrificedwhen resources are limited.

Another approach makes modified use of DCFtechniques. Attracted to business portfolio mod-els, some companies arbitrarily adjust hurdlerates according to a prior strategic classificationof the business {whether to grow, sustain, or har-vest it). Routine quantitative decision rules thenproduce the "right" answers. Despite the appear-ance of rigor with adjusted hurdle rates, however,managers may create the worst of both worlds.The true present value of cash flows is obscuredwhile the potentially valuable application of exec-utive experience and judgment is blunted.

chance to enter a market unprotected by high harriersor to build a nev r plant to service a particular geo-graphic market. Projects to cut costs are also sharedoptions since competitors usually can and will respondwith cost reductions of their own, thus minimizingthe benefits to any one company.

Shared growth options are less attrac-tive than proprietary ones hecause counter invest-ments hy the competition can erode or even preemptprofits. Only if a company is in a sufficiently strongcompetitive position to ward off assaults and grah thelion's share t)f a project's value can a shared growthoption he valuable.

Implications for capitalbudgeting

Thinking of investments as growthoptions challenges conventional wisdom ahout capitalbudgeting. For example, a eompany may he justified inaccepting projects with a negative NPV Some projects,such as the one in tbe opening example, may initiallydrain casb flows. But they may also create options forfuture growtb. If the growth option's value more thanoffsets that lost from the project's cash flows, then it isworthwhile.

Suppose a company found tbe presentvalue of construction and future operating costs for agenetic engineering lab to total $5 million. As a basicresearcb lah, it would not, of course, generate positivecash flows, only opportunities for future commercialdevelopment of new discoveries. Still, the projeetwould be justifiable if, in management's judgment,these growth options were wortb $5 million or more.

If new growtb options arc involved,bigb-risk projects migbt be preferable to low-risk ones.In light of the beneficial impact of risk on grc^wtboption value, companies sbould bold options on proj-ects wbose value swings widely rather than onlyslightly over time. Projects that create new growthoptions in risky environments should have an advan-tage in the capital hudgeting process. As an executiveof a major consumer products company noted:

"If you know everything there is to knowahout a [new] product, it's not going to be a good husi-ness. There have to be some major uncertainties to beresolved. This is the only way to get a product with amajor profit opportunity." [Empbasis added. [

When capital is scarce and interest ratesrise, projects that create new growth options may heless adversely affected than those that generate onlycash. This makes tbem relatively more attractive inthe capital budgeting process. Normally, companies tilt

Options for growth 159

The asymmetry between upside gains Exhibit III Timing the commitment of capiland downside losses in option ownership*

Tendency to retainoptions until weakercompetitors exercise

Sunk cost olacquiring thegrowth option

Potentialgainsand lossesof the project

Threat of preemption.but market power ofdominant companiesincreases their ability toappropriate the value ofexercised options forthemselves

Little or no ability toappropriate the full valueof an investmerit oppor-tunity

Rapid exercise ofoptions for defensive orpreemptive reasons

Dominant companiesable to fuily appropriateoption value for them-selves

No risk ot preemption:options should be hiuntil expiration

No risk of complete pre-emption, but threat ofvalue erosion due tocompetitive activity

Tendency to exerciseoptions early to preclude'erosion ot value

•As NPVol project declmss Oelow zero, Ihe value of megrowth option atopa falling and floaa ttat

ity of compound options^ their role in shaping a com-pany's strategy, and even their impact on the survivalof the organization all demand a broader analysis.A company must consider these projects as part of alarger cluster of projects or as a stream of investmentdecisions that extends over time. Given the company'sstrategy, executives should question whether a particu-lar option will hring the right investment opportuni-ties in the right markets-within a time frame suitahleto their company's needs.

The company must separate projectsthat require an immediate decision from those onwhich it can defer final action. For growth options witha shorter time frame, executives need to focus only onthe value gained or lost from acceptance. However,deferrable projects should he analyzed according to therelative costs and benefits of deferral.

Finally, the company must ask whetherit can capture the option's benefits for itself or whetherthey will be available to other competitors as well.

Disciplining project evaluations

To illustrate, let's look at a genericchemical investment and alter it to fit different cir-cumstances. A chemical company wants to build a

facility for producing a toxic LhcituLal nexi lu J user'splant. The chemical is a commodity, the taciluy is tobe owned and operated by the Loiupany. and ihc user isscheduled tu purchase a fixed pcfLLiua^c ui the plant'scapacity output under a take-oi pay cuiiiiaci It thecompany doesn't LoiistiULt the tai_iiuy uiniiLdtmcly,however, the offer expites and the usci will build andmanage a plant on its t)wn.

The cheiniLal cuuipany's uppui i Linity isa simple, expirm^. prupuctuiy giuw th upLiun 1 hecompany should evaluate it by (.aLulatnig the actpresent value of cashflows. The piujCLt's stand alonecash value in the present is the only incasua ot ihcproject's worth needed, since that is the value to begained ur lust.

Suppose this otfei docs iiut expiic with-in a year and the potential exists tin a i elaxati^n ut reg-ulations eontrolhng production ut thi. tuxiL Lhcinical.Under these cireumstanees, the Luinpany now icalizesthe new facility can be built al a iiuKh lower ^ust inthe future. At the same time, the Luinpany discoversthat the user has approached other Lhcinieal Luiupa-nies with the same offer. The euiupany classifies theprojeet as a simplt;. deferrable, shared giowth option.Again, the company needs to evaluate unly cash tlowsbut must study the inipaet of defeual un i,ash sniLC Itshares the option with eoinpctitois.The umipaiiyshould channel project evaluation into a eomparison of

160 Harvard Business Review March-Apnl 1984

potential costs and benefits from either immediateexercise or deferral.

Finally, suppose that the toxic chemicalis actually a new compound developed by the com-pany As a substitute for existing chemicals, it offersusers significant cost savings. If the facility canproduce the new compound in volume and the com-pany can prove the cost savings, it can expect demandto grow rapidly, and realize new opportunities to buildadditional production facilities. On the negative side,the compound is difficult to produce, and governmentregulations could change radically Moreover, the usercontinues to consider proposals from producers of aconventionally used chemical.

This last growth option is shared,compound, and deferrable. Even if cash flow analysisindicates that the company should reject or defer theproject, top management may accept it immediately ifpreemption by competitors could seriously erode theworth of future growth options.

A new perspective

The key advantage of the growth-optionperspective is that it integrates capital hudgeting withlong-range planning. Within the framework, eapitalbudgeting is simply the execution of a company's long-range plan.

Because investment decisions today cancreate the basis for investment decisions tomorrow,capital allocations made in any year are vital steps inthe ultimate achievement of strategic objectives. Bythe same token, a long-range plan necessarily impliesthe cultivation of particular investment opportunitiesand ean have a direct, doUars-and-cents impact on acompany's stock price in the near term as well. Thetwo activities are different hut related means to thesame end: maximizing the value of the company'sequity.

To explicitly link eapital hudgeting andlong-range planning, a company should place themboth under the supervision of a single executive or anexecutive eommittee. Top management will impose astrategie perspeetive on what might otherwise be anuncoordinated aggregation of isolated capital expen-ditures.

Operating with a growth option per-speetive allows responsible executives to focuson the single, overriding objective of enhancing thevalue of the company's equity. The capital hudgetingprocess will not be confused by linking the seeminglydivergent and mutually exclusive aims of investing forfuture growth and maintaining a high stock price in

the present. Once headquarters understands that someof the strategic benefits of investments are valuableoptions on future growth, it becomes clear that suchinvestments add to the value of the company's equity,just as do projects that yield immediate cash flow. Theonly difference: value comes initially in the form ofgrowth options rather than cash flows.

Such recognition will mark a critiealshift in exeeutive attention. A company should notspend time and effort trading off growth with ROI ormarket share with profitability Rather, the company'sfocus should be on the kind of value the investmentwill create, its durability, and the auxiliary decisionsrequired to protect or enhance it over time.

An exeeutive of a Fortune "500" com-pany once claimed that, "You simply can't put a dollarsign on a technological future that may have a tremen-dous payoff." The exeeutive may be right. But that doesnot mean future investment opportunities have novalue for the eompany's shareholders. Moreover, it cer-tainly does not mean a company should abandon ordistort the one approach available to put a dollar signon the future - the discounting of expected cash flowsusing appropriate discount rates.

To he consistent with the objective ofmaximizing equity value, executives must broadentheir perspective on the process of resource allocationso that they ean integrate "strategic" factors logicallyand systematically into the eapital budgeting process.

By thinking t)f discretionary investmentopportunities as options on real assets, exeeutives willaddress other relevant questions that have receivedlittle attention so far. How, for example, are growthoptions ereated, and which will be most valuable? Howpennanent and how liquid are growth options as com-ponents of company value? Does it matter whether acompany owns a growth option exclusively as a eollec-tivc option of the industry? What influence do industrystructure and competitive interaction have on growthoption value? What auxiliary financial decisions arerequired to permit the future conversion of growthoptions to real assets?

The answers to questions such as thesewill vary from one situation to another. Thus, thegrowth-option framework reaffirms the potentiallyvaluahle role that executive judgment and experiencecan play in the resource allocation proeess. But regard-less of the specific situation, the growth option frame-work establishes a common basis for the analysisneeded to answer fundamental questions and providesa coherent structure kn organizing the application ofexeeutive judgment. ^