Capital Budgeting: Sophisticated Technique

Capital Budgeting: Sophisticated technique.

It is clear that one of the most important questions corporate managers face is 'where to invest in, or what assets to invest in'. Primary objective is creating value to shareholders, namely increasing wealth of the company's owners.

To indicate numerically how much management adds value to the wealth of owners we can use common metric such as NPV (thereafter DCF concept, that's Discounted Cash Flow), and it can be barely calculated through following equation:

But the problem arises definitely when decisions are made on subjective, or judgmental way where r, or discount rate, and Cash Flow, are estimated incorrectly because no one can predict these measurements with precision. In general, finance is in part a matter of judgment and we simply must face that fact.

The logic behind DCF concept is purely time value of money concept, where future cash flows discounted at the risk-adjusted rate of return which in turn, indicates simultaneously risk related to cash flows and return to the owners from cash flows. Everything is Okay but once decision has been made, corporate managers will not effect on project, to be more specific, they will not be able to response to changing conditions because this concept is based merely on financial assets that have their own predetermined expected future cash flows and fixed rate1. In reality, management of the company conducts its project into the better results even after the undertaking has been made because they will always strive to improve their performance, and at last project itself represents real asset as opposed to financial asset, therefore it would be reasonable to use more sophisticated techniques to determine real added value by specific project. But we don't refuse DCF model, in effect, it can be used to Real Options that is main topic of this paper in order to determine more fair value.

There are several main types of real options such as: option to delay, growth option, abandonment option, flexibility option and etc. Option to delay is characterized when more available information is necessary, namely the project is simply deferred until required information is received to reduce uncertainty associated with market demand. Growth option provides company with favorable future opportunities to invest, if any, especially with existing product line. Abandonment option provides the alternative to reject the project at any time in order to lessen future losses. Flexibility option provides an ability to shift from one product line to another product line, to be more specific, it allows the company to switch from one expected product to another, that's, management must expect to produce two desirable products so that if one product is turned out to be out of the money, then second product will be placed into operation to offset the first and to become more successive than the first one.

We will illustrate only Option to delay because Real Options themselves are too complicated to interpret their concepts, due to only this reason at least one book is required to describe them.

1See, Eugene F. Brigham and Michael C. Ehrhardt. "Financial management," 11th edition, Chapter 12 Real Options.

For example, one project is expected to produce some product which is attached to license which gives the project the right to delay implementation until more information is available for 1 year ahead with 14% cost of capital. Suppose, the project is expected to incur $40 million and to generate $28 million payoff in a good state of demand with the probability of 25%, and second payoff is expected to be $20 million in a moderate state of demand with probability of 50%, and third payoff is expected to be $3 million in a low state of demand with probability of 25%. And this kind of assumption can fit into one standard financial option as the Black-Scholes Option Pricing Model. This model requires five inputs: 1) the risk-free rate, 2) the time until the project is placed into operation, 3) investment