The Dryden Press: Finance: Brigham

ISBN: 0-03-028931-9

Chapter 13 Other Topics in Capital BudgetingS

Keeping Your Options Open
The last two chapters described the basic procedures used in capital budgeting, whose cornerstone is net present value analysis. NPV is particularly appealing because it provides a single, convenient measure of projects' overall value.
However, many practitioners argue that basic NPV analysis is frequently shortsighted because it assumes that a project's expected cash flows are locked in once it has been accepted, whereas in reality managers are often able to react to changing circumstances, thereby altering the cash flow stream. Consequently, when considering a potential project, managers should recognize that a variety of scenarios can unfold during the life of the project, and that their decisions over time will influence its cash flows and ultimate value.
In this chapter, we describe a technique, real option analysis, that has been developed to deal with this situation. It starts from the premise that many projects include embedded options, or choices, that influence the project's true value. For example, a firm using real option analysis might accept a project that has a negative NPV as calculated on the basis of its own cash flows because management recognizes that the project, while unprofitable, may create the opportunity to develop other highly profitable projects in the future. In other circumstances, real option analysis might suggest delaying a positive NPV project because the firm has the option to pursue the project at a later date, when better estimates of the cash flows and risk will be available.
A recent article in Business Week illustrated how leading corporations are using real option analysis. For example, Enron Corporation decided to construct three power plants that appeared at first blush to be highly inefficient because their marginal costs for producing electricity were 70 percent higher than the industry average. However, Enron planned to use these plants only during peak periods, when electricity prices rise to very high levels. Although the plants were inefficient, they could be constructed at a very low cost, thereby giving the company a relatively low-cost option to expand its production at opportune times.
The Business Week article went on to describe how Hewlett-Packard, Airbus, and Cadence Design, among others, use real option analysis in their decision-making processes. While some types of real option analysis are quite complex and go beyond the scope of this book, many of the basic principles can be described in simple terms. After reading this chapter, you should see the implications this type of analysis has for corporate decision making.

DISCUSSION QUESTIONS

Do you agree with the idea of "real options" in evaluating projects or do you think that investment decisions should be based upon more traditional measures?
Do you foresee any possible downsides to incorporating real options in capital budgeting analysis?

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