Real Options, Investment Analysis and Process

Chapter - 13

Real Options, Investment Analysis and Process

2Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Chapter Objectives

Understand the capital budgeting process: Document the policies and practices of

companies in India and compare them with that of the companies in developed countries.

Understand the linkage between corporate strategy and investment decisions.

Define strategic real options. Show the valuation of real options.


We will answer the following questions

What is the process of capital budgeting that companies employ?

What capital budgeting policies and practices do they follow?

Is there any link between the corporate strategy and capital budgeting?

What are the strategic aspects of capital budgeting? Can the discounted cash flow technique handle the

strategic aspects of capital investments? How can we evaluate investment projects that are

capable of creating future opportunities and flexibility (options) for companies?


Capital Investments Capital investments should include all those

expenditures, which are expected to produce benefits to the firm over a long period of time, and encompass both tangible and intangible assets. Thus R&D expenditure is a capital investment. Similarly, the expenditure incurred in acquiring a patent or brand is also a capital investment.

Few companies classify capital expenditures in a manner, which could provide useful information for decision-making. Their classification is (i) replacement, (ii) modernisation, (iii) expansion, (iv) new project, (v) research and development, (vi) diversification, and (vii) cost reduction.


Capital Investment Planning and Control At least five phases of capital expenditure

planning and control can be identified: Identification (or origination) of investment

opportunities. Development of forecasts of benefits and costs. Evaluation of the net benefits. Authorisation for progressing and spending capital

expenditure. Control of capital projects.


Investment Ideas: Who Generates Most proposals, in the nature of cost reduction or

replacement or process or product improvements take place at plant level.

The contribution of top management in generating investment ideas is generally confined to expansion or diversification projects.

The proposals may originate systematically or haphazardly in a firm.

The most common methods used are: management sponsored studies for project identification, formal suggestion schemes, consulting advice. review of researches done in the country or abroad, conducting market surveys, deputing executives to international trade fairs for identifying new

products/technology.


Developing Cash Flow Estimates

Estimation of cash flows requires collection and analysis of all qualitative and quantitative data, both financial and non-financial in nature. Large companies would generally have a management information system (MIS) providing such data.


Project Evaluation The net present value method is theoretically

the most desirable criterion as it is a true measure of profitability; it generally ranks projects correctly and is consistent with the wealth maximization criterion. In practice, however, managers’ choice may be governed by other practical considerations also.

Some Important Factors Cut-off Rate Recognition of Risk Capital Rationing


Authorisation Screening and selection procedures may

differ from one company to another. When large sums of capital expenditures are involved, the authority for the final approval may rest with top management. The approval authority may be delegated for certain types of investment projects.

Senior management tightly control capital spending. Budgetary control is also exercised rigidly. The expected capital expenditure proposals invariably become a part of the annual capital budget in all companies.


Control and Monitoring Advantages of reappraisal:

(i) improvement in profitability by positioning the project as per the original plan;

(ii) ascertainment of errors in investment planning which can be avoided in future;

(iii) guidance for future evaluation of projects; and (iv) generation of cost consciousness among the

project team.

A few companies abandon the project if it becomes uneconomical.


Qualitative Factors and Judgement in Capital Budgeting In practice, however, companies, although tending to

shift to the formal methods of evaluation, give considerable importance to qualitative factors.

Most companies in India are guided, one time or other, by three qualitative factors: urgency, strategy, and environment.

Some companies also consider intuition, security and social considerations as important qualitative factors.

Companies in USA consider qualitative factors like employees’ morals and safety, investor and customer image, or legal matters important in investment analysis.


Role of Judgement Vision of judgement of the future plays an important role. The opportunities and constraints of selecting a project, its

evaluation of qualitative and quantitative factors, and the weightage on every bit of pros and cons, cost-benefit analysis, etc., are essential elements of judgement.

Judgement and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company. For routine matters, liquidity and profits should be preferred over judgement.

It (judgement) plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects.


Investment Decisions and Corporate Strategy Strategy provides the decision-maker with a central

theme or a big picture to keep in mind at all times as a guideline for effectively allocating corporate financial resources.

As argued by a chief financial officer—Allocating resources to investments without a sound concept of divisional and corporate strategy is a lot like throwing darts in a dark room.

Strategic framework provides a higher-level screening and an integrating perspective to the whole system of capital expenditure planning and control. Once strategic questions have been answered, investment proposals may be subjected to the DCF evaluation.


Managerial Flexibility and Commitment

STRATEGIC REAL OPTIONS – Real options are those strategic elements in

investments that help creating flexibility of operations, or that have the potential of generating profitable opportunities in the future for the firm.

Real options provide discretion to managers to take certain investment decisions, without any obligation, for a given price.

Real options are not confined to real assets only. Patent, R&D, brands etc. are examples of assets that have a value to the owner.

The capital investments should be viewed as strategic investments that incorporate real options. Hence the value of a capital investment will also include the value of the strategic elements in the investment.


Valuing Real Option

An investment with real option consists of two values: the value of cash flows from the project’s assets plus the value of any future opportunity (option) arising from holding the asset.

We use the Binomial method and Black-Scholes method of option pricing for valuing real options.


Types of Real Options Valuing Option to Expand Valuing a Patent Valuing The Option To Abandon Valuing Option to Delay Flexibility and Operating Options


Capital Budgeting Decision-making Levels For planning and control purposes, three levels of

decision-making have been identified: Operating, administrative, and strategic.

Keeping in view the different decision-making levels, capital expenditures could be classified in a way, which would reflect the appropriate managerial efforts to be placed in planning and controlling them. One useful classification could be:

(i) strategic projects, (ii) expansion in the new line of business, (iii) general replacement projects, (iv) expansion in the existing line of business, and (v) statutory required and welfare projects.

Education

Real Options, Investment Analysis and Process