Home > Business related > Capital Budgeting, Real Options, & Bending Grass

Capital Budgeting, Real Options, & Bending Grass

Trees, no matter how well rooted they are, topple over from gusts of winds due to their inflexibility. But Confucius noted that “when the wind blows, the grass bends”. Thus, adaptability to the surrounding environment, plays a big role in survival. Against such backdrop, do I put into perspective the topic of Real Options; and how that aids management in better project selection; making them more adaptable.

Companies are established to generate wealth to its stakeholders. In doing so, a company must be working towards a vision; which is synonymous to the company’s central theme. By working towards their vision, companies take on and execute various projects. But since a company’s main object is to maximize the wealth of its stakeholders, management must have a way [or a tool] to help them select the most profitable projects. This is where Capital Budgeting comes into play.

In a nutshell, capital budgeting is the process of “making and managing expenditures on long-lived assets” (Ross et. al, 2008, p.2). Management must determine the cash inflows and outflows of a given project to determine its suitability relative to:

  • How the cash flows affect the stakeholders’ overall wealth
  • How the cash flows measure against the cash flows of other potential projects that management could undertake instead

Given that companies have limited funds (or fund sources), management must select those projects that create the most financial benefit to the shareholders.

But the process of selecting projects is not as trivial as portrayed above. A company exists in a complex environment, whereby a lot of factors are interconnected and in play. In fact, market environments are so complex, that they are semi-deterministic; they cannot be modeled with 100% accuracy, yet they are not chaotic. Thus uncertainty complicates the project selection process, as future cash inflows and outflows are only known with a given degree of accuracy.

In solving the project selection problem, various investment decision tools have been devised to assist managers; most prominent of which are:

  • Net Present Value (NPV): whereby the future cash inflows and outflows are discounted back to present money and all added up. The project with the highest NPV value will be the clear winner, as it maximizes shareholder’s wealth.
  • Internal Rate of Return (IRR): the IRR is the rate were a project does not contribute any gains or losses to the shareholders’ wealth – thus management would be indifferent about executing it. With this tool, managers compare the rate of return of a given project against its IRR to determine its level of profitability. The project that produces that highest profitability is selected.
  • Payback Period: Projects are determined on how quickly the cash inflows payback the initial investment [cash outflow]. The fastest project is selected.

Though this is by no means an exhaustive list, each method has its short comings. These methods were “designed for relatively stable environments… As a result, business strategy … turn out to be flawed because something outside their control doesn’t go as planned” (Trigeorgis et al., 2007). What was need is another method, that accounts for uncertainty and management’s ability to respond to future events; thus the method of Real Options came about.

“At its core, the real option perspective is like other theories of investment in that it is concerned with identifying the factors that influence the investor’s threshold —the point at which investors choose whether to invest or not” (Miller and Flota, 2002). What the real options method did differently, is that it introduced the concept of “the possibility of contingent decisions” (Amram and Kulatilaka, 1999). The method was a bit more chaotic compared to other methods, in the sense that it was more reflective of reality. Thus it accounted for situations of project expansion, contraction, abandonment, timing of events, and “sequential [growth] options [of other projects]” (Wyant, 2009). By explicitly accounting for the future flexibility inherent in capital investment opportunities, the real option method would better portray the real financial effect of a given project on shareholders’ wealth.

The main benefits of the real options method is that it facilities for better planning and in taking strategic decisions. Other methods might be too conservative in analyzing the benefits of a project, which would result in its rejection. The reason why the other methods suffer from such consevatism, is because they commit project decisions at the beginning stages, which results in “sacrificing flexibility and increasing exposure to … uncertainties of new markets” (Miller and Flota, 2002). Therefore with the real options method, better strategic modeling is conducted, which results in flexible project variability, a more informed management and lower costs [cash flows].

At my current place of employment, a financial leasing company, we constantly use the real options method. Since our funds are limited, we are selective with the clients we are willing to finance. In determining the risk profile of the client, we attach probabilities to our future relationship directions with the client: increase/decrease/or cap the exposure, perform repossession in the event of a payment defaults, file a lawsuit, etc. Based on such analysis, we are able “to better quantify the value of each contingency” (Trigeorgis et al., 2007) and effectively better handle our client base and overall company risk and returns.

~ Youssef Aboul-Naja

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  1. Anonymous
    March 1, 2010 at 6:31 PM

    It’s interesting how you pick your topics, very well selected. Is this coming from an academic program or something? Would be nice if you can post your references. Y’re shedding some light into the numeral aspects of business, but as they say: “the covers of a book are too far apart”. A clever glimpse as such is worth unfolding.

  2. Anonymous
    March 1, 2010 at 6:32 PM

    Oops! I mean to say “You’re” not “Y’re”

  3. hindoldatta
    April 12, 2010 at 9:43 AM

    Excellent posts. I am doing something a little different but i will definitely link to your blog. Thanks for work and the materials. Check out my blog

    financeprimer.wordpress.com

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