“The intuitions gained from the real options approach to capital budgeting are always useful, but the approach is very difficult, if not impossible, to implement.” Discuss, using illustrative examples where appropriate.
Capital Budgeting
Capital budgeting comprises a vital aspect of investment and marketing decisions. Decisions covering investment options involve time in considering the relative expected returns from the various options. Options deemed to lead to low levels of return would be rejected while the investment option offering high rates of return would likely be considered for investment. A requisite in determining the relative rate of return of investment options is the expected maturation period of the investment or the period within which returns are expected to be earned. Examples of investment options for a manufacturing firm include the expansion of the production plant, addition of machines or hiring of new workers due to an expected increase in demand. Decisions involving marketing decision options involve the ways of increasing sales such as boosting advertising campaigns, enhancing the training of sales personnel, or increasing the number of sales personnel. The decision largely depends upon certain measures such as the ratio or sales to advertising that expresses the impact of the enhanced advertising campaign to increase in sales. Although, the impact of advertising on sales is difficult to measure, the ratio serves as an important means of supporting marketing decisions. Throughout the process of investment and marketing decision-making, capital budgeting serves as the means through which the decision is achieved including the laying out of the factors that need to be considered based on business context and actions when certain factors arise.
Capital budgeting also constitutes an important aspect of financial management particularly of capital assets. Even if capital assets constitute only a small component of the total assets of the company relative to current assets, decisions on capital assets involve long term effects. This means that the decision on capital expenditures should be made with care because mistakes would be felt by the firm in the long run. The usual motivation for firms to engage in capital expenditure decision involves expansion, modernisation, replacement or strategy. In order to achieve these goals and avoid mistakes, capital budgeting is used as the encompassing process that involves the generation, evaluation, selection and follow-up of capital expenditure decisions. In recognition of the importance of capital budgeting, business organisations especially large firms develop or adopt approaches in applying the capital budgeting analytical process.
Real Options Approach
(1996) describes the real options approach as the new valuation, strategic decision-making and project management paradigm that addresses the weaknesses of traditional approaches by allowing for flexible decisions amidst uncertainty. This description implies several things about real options approach.
First is the status of the approach as an alternative to traditional capital expenditure decision paradigms of Net Present Value (NPV). Net Present Value is a decision-making measure that sets out the difference in the value derived from the capital expenditure relative to the cost through the formula where: t is time of cash flow; n is total activity time; r is discount rate; Ct is net cash flow (amount of cash) for time t; and
C0 is capital outlay at the start of time t. If the NPV value derived is greater than 0 the positive value represent that value added to the business so that the capital expenditure plan should be subject to approval, if the NPV value is equal to 0 implementing the capital expenditure plan would not contribute any gains to the company but there would also be no loss so that the plan will not benefit the firm, and if the NPV value is less than 0 the negative value represents the loss expected to be incurred by the business so that the more that the plan should be scrapped. (, & 2001) Although deemed as the traditional approach to capital budgeting, NPV is still extensively used. This is because according to (1996), this approach is the only analytical measure that works with lack of “managerial flexibility” that is “consistent with a firm’s objective of maximizing its shareholder’s wealth” (). However, there are alternative analytical tools that address the weakness of NPV of not including the option of delaying irreversible capital expenditures ( & 1994) because the conclusion of the measure is only whether or not to push through with a plan. Real options approach as an alternative to NPV works by empowering decision-makers to hold the right to proceed with a capital expenditure plan instead of obligating them to make the decision. Real options approach then provides decision-makers with the option to test the waters first before diving head on to open water even if the plan has already achieved a positive NPV value. This is consistent with the recognition of capital budgeting as involving long term effects whether the effect is positive or negative so that the decision-maker needs greater assurance before taking the risk through vigilance over changes in business context or environment or in the capital assets.
Second is the role of the real options approach as a paradigm, pattern or guide for business firms. Applying the real options approach is akin to playing poker. All the players have their money to bet. They lay their ante on the table before the cards are dealt. The traditional approach would urge the players to place or raise their bets if they consider as high the value of their cards and due to the expectations of winnings in the amount of the ante and bets taken together. However, the players are not aware of the value of the other players’ cards, which could be higher or lower so that most of the players would have to part with their money leaving them with nothing. In applying real options approach, players believing that their cards hold a high value are urged to match the highest bet to proceed to the next stage of opening new cards and discarding to obtain new cards to ensure greater assurance of winning. The entire game also involves the process of assessing what the other players are thinking and making a decision based on the value of the cards as well as the perceived or expected action of the other players. In this way, the player either folds due to the knowledge that there is too high a risk involved or plays all out for the win.
Third is the ability of the approach to allow decision-makers flexibility in the decision-making process because of the inevitable intervention of uncertainty so that the decision-maker necessarily have to rely upon intuition. This is again captured by the game of poker. Flexibility amidts uncertainty is also captured in the key concepts of the real options approach.
One key concept is investment defined as the action of having immediate costs with the expectation of future returns ( & 1994). Uncertainty in investment pertains to the risk involved in implementing a capital expenditure plan. However, flexibility arises in applying the real options approach through particular risk-reduction activities such as engaging in research and development to support the viability of a product concept and patenting the product design in order to have exclusive rights to it and incur added value or implementing an introductory promo to determine the reception of the market to an innovative product before actually engaging in mass production. Even if positive returns are expected, decision-makers have the flexibility to alter the capital expenditure plan or deviate from it based on the results of initial testing and intuitive business sense.
This means that the real options approach does not only limit the decision-maker to the isse of whether or not to go through with a capital expenditure plan but also the issues of the ways of achieving the plan, assessment of achievements or performance, and adjustment of the plan directed towards the purpose not only of ensuring returns but also the highest possible returns due to minimised risks and costs ( & 1995).
Another key concept is sunk cost, which pertains to the outlay that has already been committed ( & 1996). The implication of a sunk cost is its irreversibility especially if the capital expenditure uniquely pertains to a company or industry. The areas of advertising and marketing are both company specific so that these involve sunk costs that are irreversible and unrecoverable. Other factors contributing to irreversibility also include the application of government regulations, institution-based arrangements, and coporate culture differences usually experienced by globalising businesses such that capital controls make it selling or reallocation of assets difficult.
Due to the irreversibility of decision applications on capital expenditures, the decision-making process should involve intense analyses because after capital assets have been allocated or placed, investments on such assets cannot be made null or return the company to its previous situation before the investment. With the real options approach, decision-makers apply the prerogative to delay the project up to a period when salient aspects of the uncertainty have been settled. This is usually applied through the breakdown of the plan in various successive stages with the implementation advancing as risks or uncertainties in one preceeding stage is addressed ( & 1999).
Another key concept is uncertainty, which pertains to the encompassing term covering situations involving unknown factors such as the future developments or the effects of the variables involved ( & 1999). Unknown does not necessarily mean that this is not discoverable. In the case of capital expenditures, certainty refers to the situation where the investor knows or has expectations on future investment returns so that uncertainty constitutes the collection of positive and negative values that could occur. Uncertainty is expressed in the price of fuel in the future that could increase or decrease giving a dual side to uncertainty.
Generally, there are two aspects of uncertainty, which are economic uncertainty and technical uncertainty. Economic uncertainty finds link with the general economic shifts in variables exogenous to the decision-making process because these are not significantly influenced by the business firm ( & 1994). Due to the exogenous nature of the shifting variables, the application of the real option approach is through the postponement of decision applications or cutting the plan into stages and awaiting positive changes in these economic variables. Technical uncertainty pertains to the unknown linked to shifts in variables endogenous to the business firm ( & 1994). This is exemplified by oil exploration venture. The certainty or uncertainty of unearthing oil is actually minimized through the actual investment on the oil exploration. Without this initial investment, the company will never be able to settle the issue of uncertainty. In this instance, real options approach applies through careful and step-by-step planning and examination of actual business context of the uncertainty.
Another key concept is flexibility, which refers to the capacity to abandon, defer, contract or expand investments every time that new information arrives on matters previously unknown to the decision-makers or on effects different from what was expected ( 1995). This applies to the case of the oil exploration. As the crew digs deeper into the earth and expenses mount, information is obtained over the probable or actual existence of oil so that depending upon the developing events decision-makers should be able to adjust to the situation by resulting to the pulling out of the team, transfer of site, or infusion of more funds. The soundness and viability of the decision and the adjustability of the decision-maker to changing conditions depends largely on the ability to weigh and analyse these changes ( 1996). Real option approach then urge decision-makers to develop a good perception of these changes in order to support adjustability.
Another key concept is contingency that pertains to the situation when future capital expenditures depend upon the viability of present expenditures ( 1996). This finds expression in the engagement of the firm to present investments even with negative NPV in order to build or realise value necessary to incur future returns. This is exemplified by a drug manufacturer that invests on research and development as well as testing in order to settle any problems with health value of the drug prior to actual marketing. Without incurring investments, the firm will never realise future returns from the mass marketing of the drug.
The link between the successful application of contingency and real options approach is the intuitive character of decision-makers ( & 2000) that is necessary in knowing what, when, where, how and why to delay the completion of the capital expenditure plan until after the results of pilot studies have been analysed. Since the result of the pilot study or the completion of the investment is uncertain, decision-makers should be adept at contingent decision-making. Real options approach then supports contingent decision-making through its valuation paradigm that compares the measures derived for the capital investment decision with benchmarks or previous company and industry statistics.
The last key concept is volatility or instability of investment variables resulting to a range of probable outcomes depending upon the occurrence or intervention of certain variables. The degree of dispersion of these potential outcomes determines the degree of risk and uncertainty of the variable. ( & 1999) From an intuitive perspective, investments involving higher degrees of volatility translate to greater option value. In the traditional capital budgeting approach, greater volatility rates pertain to higher discount rates as well as low NPVs. The difference in perspective shows that real option approach enables decision-makers to consider even the unimaginable, which usually offers greater returns.
Real option approach then provides decision-makers with the option to delay or stagger the implementation of the capital budgeting plan even with a positive NPV value in order to maximize returns for the firm. By delaying implementation, greater areas of uncertainty are controlled ensuring greater returns for the company.
Overall, applying the real options approach develops intuitive decision-making in the case of capital budgeting that involves irreversible or long term consequences. On the surface this seems easy to accomplish with decision-makers relying upon their good business sense developed from experience in decision-making in the context of the firm, industry and economy. However, intuition is a cognitive process that is variable and relative. This means that even with guidance from previous experiences and industry trends, the decision would be difference for similar companies intending to engage in the same capital expenditure plan so that there would also be difference results. Nevertheless, there are also real option approach concepts that support this intuitive endeavour such as those discussed above applied in a continuous learning process that involves both failures and successes. Even if the process of mastering the intuitive decision-making through the application of the real options approach in capital budgeting is difficult, it is not impossible because of expected positive long term benefits to decision-makers and the business firm.
Applying the Real Options Approach in Capital Budgeting
Applying the real options approach in capital budgeting to achieve intuitive expertise involves the consideration of measures or benchmarks, the analyses of these measures, and then the development of contingencies for various expected scenarios and outcomes.
There are a number of measures available as measures necessary in capital budgeting. One measure determines the rate of return of investments. Real options approach modifies the NPV by considering only 0 or a positive value as the result. A modified NPV of 0 or a positive value means that the company has the option to push through with the plan, stagger the implementation, delay implementation, cancel implementation, and other options available to the decision-maker depending upon the context of the firm, industry and the overall business environment. ( 1996)
Another measure covers uncertainty. Variance expressed through this symbol σ2 is a measure of the extent of uncertainty. However, since the derivation of information in the course of the delayed or staggered implementation of the plan involves time the variance measure becomes σ2 t. A higher resulting value indicates greater uncertainty while a lower value means otherwise. Moreover, variance can also be measured through standard deviation so that a higher standard deviation value means greater uncertainty and vice versa. ( & 1999)
These measures are then considered in the valuation of different options by looking collectively at these factors: present value of operating assets; expenditures in asset acquisition involved in the capital expenditure plan; period of deferring the decision; value of money over the different time periods; and degree of risk integrated into the assets.
From the information, the decision-maker then considers the various options and even with the selection of a particular option the exercise of the option is made flexible and subject to adjustments as new information is derived or changes occur in the plan. This means that while the measures provide a foundation for the decision, decision-makers still rely upon the rise of other options through time. Decision-makers then need to recognize these options and shifts in options, analyse these options in terms of the plan and the information derived, develop future scenarios and expectations, and move according to what is perceived as the most optimal action. Through the continuous engagement in these processes, decision-makers learn to spot changes, recognise the importance of options and flexibility, determine opportunities, and act flexibly decision makers end-up developing intuitive values. Ultimately, the continuous engagement in the difficult process of adopting real options approach to capital budgeting enhances the intuitive skills of decision-makers and brings in maximum benefits to the business firm.
Conclusion
Decision-making involving uncertain variables is difficult but doable. In the case of capital budgeting that involves irreversible impact of actions, decision-makers necessarily have to apply great care in deciding whether to push through or defer an investment plan. Real option approach supports decision-making through the consideration of a combination of measures as well as analytical skills on the part of decision-makers. This applies through the recognition of risk and integration of flexibility, volatility and contingency in the process. Although the decision-making process over uncertainty involves difficulties, it also results to long term benefits to decision-makers and the business firm. On the part of decision-makers, engagement in the process allows them to develop intuitive value through practical involvement in real options valuation and processing while on the part of the business firm intuitive value translates into maximised returns.
References
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