Real Options in Capital Budgeting

Real Options in Capital Budgeting
The usual capital spending or budgeting techniques guide financial managers of companies in making accept or reject decisions about specific projects and assets. They do not guide these managers in areas related to the project after it has been initiated. The managers using only these techniques would not be able to change their decisions when the project has started. One assumption of capital budgeting is that if a project is accepted it will continue without any consideration of actual cash flows. Real options play a vital role for managers in this area. The managers have options through which they can adjust projects according to the changing trends of the market. These options are often referred to as real options, managerial options or strategic options. The managers can adjust projects according to change in economical conditions, market competition and varying growth trends using real options. The managers have to recognize the options available in a project and generate newer options for each project. The various real options available in a project include investment timing options, abandonment options, growth options and flexibility options (Brigham & Ehrhardt, 2001). The capital budgeting techniques offer two alternatives for management either to accept the project or reject it.
There is another option available with these two alternatives which is investment timing, where the investment in a project can be delayed to a future date. For example suppose IBM plans to manufacture computers based on advanced technology, Microsoft has the option to immediately start creating the software that would be required for the new computers or delay the development to a later stage when IBM is ready to launch its computers in the market. This option is viable only if the delay compensates for any loss in market share of the software. The second option available to managers during a project is the abandonment option which enables them to abandon or discard any project before its life when it starts to have an adverse affect on the project’s cash flows. The abandonment option is used when the cash flows of a project are affected adversely by changing environments. For example a project which had a positive NPV is started but after two years due to severe economic conditions the projects cash flows become negative then the managers can decide to abandon the project at this point if the option is available. The growth option enables managers to enhance projects with growth in demand and sales. The managers can decide to add more components to a project or make it more geographically diversified to meet the increase in demands and benefit from new geographical markets.

The flexibility option makes projects more flexible to changing trends and market conditions. Suppose a company is planning to setup a manufacturing plant for shoes which would produce sports shoes for various age groups. Though the NPV of the future cash flows is positive, the management has an option to establish a plant with some extra capital spending to make it flexible to shifts in demand of shoes. If the demand for sports shoes declines and that for formal shoes rises, the company would be able to cope with this shift in demand by increasing the production of formal shoes and decreasing sports shoes production. The real options available to managers can be evaluated by various methods which include the following: Using the traditional capital budgeting techniques and assuming the values of real options to be zero, Second valuation technique is to use the same traditional approach and include a qualitative identification of real options, Third techniques is to use decision trees, and the last technique is to adapt the financial option model and value real options specific to various projects. The most common technique for valuing and analyzing real options is to apply the Black-Scholes model for call and put options (Brach, 2003). The management of the company can diversify the capital spending structure by applying any one of the real options in various scenarios.

Brach, A. M. (2003). Real Options in Practice. New Jersey: John Wiley & Sons, Inc.
Brigham, E., & Ehrhardt, M. (2001). Financial Management: Theory and Practice 11th Edition. Florence: South-Western Educational Publishing.

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