Real Options in Capital Budgeting

To analyze a proposed capital budgeting project using NPV, it is necessary to make estimates of expected future cash flows and an appropriate discount rate. At the most basic level, management can calculate a single NPV, decide to embark upon a project, and then wait until the project’s term runs its course—a decidedly passive approach. However, a project’s NPV can be calculated only with information known at the time the estimates are made, and the choice is between accepting or rejecting the project. Thus, the NPV approach ignores the fact that other choices may be made and that the option to make those other choices can have value.

The real options approach addresses the problem of optimizing a real asset (such as a piece of equipment, a building, land, a project, and so forth) under conditions of uncertainty, given the available options. Real options goes beyond the basic passive approach to NPV and project management. Instead, real options provide a framework for strategic decision-making as the project goes along. In essence, real options begin with an initial choice that is then followed by additional choices that factor in as more information becomes available.

Those who employ the real options approach consider capital budgeting investment opportunities as if they were American call options, with the exercise price as the investment amount and the underlying asset as the project. The act of investing may create new options, such as the option to abandon a project or the option to expand it. Having an option to abandon a capital project is similar to owning a put option, which is the right but not the obligation to sell the project at a set price before a certain expiration date. Real options have value, in the same way that put and call options have value.

For example, a company might consider a project that, while attractive, has a negative NPV. Under most conditions, the company should avoid the project. However, it is possible that, based on real options analysis, a company might be more willing to undertake such a project because it could offer expansion opportunities or because it could be abandoned if conditions turned unfavorable. Moreover, the company could even restart the project later if conditions turned favorable. These types of options—the flexibility to stop, restart, or reconsider—can have specific values assigned to them. It is possible that a negative NPV project would be undertaken because of the value of its options.

The following is a list of a few common real options:

1- The option to make follow-on investments if the immediate investment project succeeds. For example, a company is evaluating an investment in a new $100 million plant to manufacture a newly-developed product, but the project would require very high sales volume to result in a positive NPV. A real option could be to build a smaller plant instead for only $10 million, then wait to see if the new product is successful. If the product does sell well, then the $100 million plant could be built. In this example, the cost of the option is $10 million. The company is acquiring a
real option to expand while obtaining strategic “first-mover” (that is, first into a market) advantage.

2- The option to abandon a project. If actual cash flows turn out to be much lower than forecasted, it is helpful to have the option to cancel a project and recover the investment by selling it. If the abandonment value of the assets is greater than the present value of the future expected cash flows from continuing the project, the project can and ought to be abandoned. Thus, the option to abandon a project is comparable to a put option on a financial asset.
A project might be temporarily abandoned if actual cash flow is below forecasted cash flow and then revived when market conditions improve and prices rebound. The project’s value may be greater with an abandonment option than without one.

3- The option to wait and learn more before investing. A real options approach can be taken to find the optimal timing of an investment. For example, if a project’s expected net cash flows are high, the company may want to invest without delay in order to capture those cash flows. However, if the forecasted cash flows are lower, managers may be more inclined to wait to invest, even if the NPV of the project is positive. The company could wait another year to learn more about the market for the proposed project. Therefore, if an outcome’s potential is highly variable, it may be more valuable to take the wait and learn option.

For example, a company owns a tract of land that it wishes to develop into a revenue-generating enterprise. However, once the land has been converted to a particular use, its flexibility becomes limited and its function can be changed only after great expense. By waiting, the company can observe changes in values of developed properties in the same neighborhood to make better estimates of expected cash flows from alternative investments. As time passes, expected cash flows from one of the investment alternatives may emerge as being significantly higher than the others.

The greater the variability in possible outcomes is, the greater is the value of the option to wait and learn.

4- The option to vary the inputs to the production process, the production methods, or the firm’s output or product mix. Equipment can be designed to operate in different ways or with different raw materials, depending upon specific conditions. Production can be shifted from one product to another to adapt to changing market demands. Even if this shift increases production cost, it can result in additional cash flow if the alternative would be production of a product that is not marketable due to insufficient demand.

Upton adds the following examples:

1. Growth options. An example of a growth option is the decision to invest in entry into a new market.
2. Flexibility options. An example of a flexibility option is the choice between building a single, centrally located facility or two facilities in different locations