REAL OPTIONS; INVESTMENT STRATEGY

CHAPTER 13 AND PROCESS

 LEARNING OBJECTIVES
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Understand the capital budgeting process

Document the policies and practices of companies in India
and compare them with that of the companies in developed
countries
Understand the linkage between corporate strategy and
investment decisions
Define strategic real options
Show the valuation of real options
 We will answer the following questions:
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 What is the process of capital budgeting that companies

employ?
 What capital budgeting policies and practices do they follow?
 Is there any link between the corporate strategy and capital
budgeting?
 What are the strategic aspects of capital budgeting?
 Can the discounted cash flow technique handle the strategic
aspects of capital investments?
 How can we evaluate investment projects that are capable of
creating future opportunities and flexibility (options) for
companies?
 CAPITAL INVESTMENTS
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 Capital investments should include all those expenditures,

which are expected to produce benefits to the firm over a
long period of time, and encompass both tangible and
intangible assets. Thus, R&D expenditure is a capital
investment. Similarly, the expenditure incurred in acquiring a
patent or brand is also a capital investment.

 Few companies classify capital expenditures in a manner,

which could provide useful information for decision-making.

 Their classification is (i) replacement, (ii) modernisation,

(iii) expansion, (iv) new project, (v) research and
development, (vi) diversification, and (vii) cost reduction.
CAPITAL INVESTMENT PLANNING AND CONTROL
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 At least five phases of capital expenditure planning and

control can be identified:
 Identification (or origination) of investment opportunities.
 Development of forecasts of benefits and costs.
 Evaluation of the net benefits.
 Authorisation for progressing and spending capital expenditure.
 Control of capital projects.
 Investment Ideas: Who Generates?
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 Most proposals, in the nature of cost reduction or replacement or

process or product improvements take place at plant level.
 The contribution of top management in generating investment
ideas is generally confined to expansion or diversification
projects.
 The proposals may originate systematically or haphazardly in a
firm.
 The most common methods used are:
 management sponsored studies for project identification;
 formal suggestion schemes;
 consulting advice;
 review of researches done in the country or abroad;
 conducting market surveys and
 deputing executives to international trade fairs for identifying
new products/technology.
 Developing Cash Flow Estimates
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 Estimation of cash flows requires collection and

analysis of all qualitative and quantitative data, both
financial and non-financial in nature. Large
companies would generally have a management
information system (MIS) providing such data.
 Project Evaluation
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 The net present value method is theoretically the

most desirable criterion as it is a true measure of
profitability; it generally ranks projects correctly
and is consistent with the wealth maximization
criterion. In practice, however, managers’ choice
may be governed by other practical considerations
also.
 Some Important Factors
 Cut-off Rate
 Recognition of Risk
 Capital Rationing
 Authorisation
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 Screening and selection procedures may differ from one company

to another. When large sums of capital expenditures are involved,
the authority for the final approval may rest with top management.
The approval authority may be delegated for certain types of
investment projects.

 Senior management tightly control capital spending. Budgetary

control is also exercised rigidly. The expected capital expenditure
proposals invariably become a part of the annual capital budget in
all companies.

 Some companies also have formal long-range plans covering a

period of 3 to 5 years.
 Control and Monitoring
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 Advantages of reappraisal:
 (i) improvement in profitability by positioning the project as
per the original plan;
 (ii) ascertainment of errors in investment planning which
can be avoided in future;
 (iii) guidance for future evaluation of projects; and
 (iv) generation of cost consciousness among the project
team.
 A fewcompanies abandon the project if it becomes
uneconomical.
 QUALITATIVE FACTORS AND JUDGMENT IN CAPITAL
BUDGETING
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 In practice, companies, although tending to shift to the formal

methods of evaluation, give considerable importance to qualitative
factors.
 Most companies in India are guided, one time or other, by three
qualitative factors: urgency, strategy, and environment.
 Some companies also consider intuition, security and social
considerations as important qualitative factors.
 Companies in USA consider qualitative factors like employees’
morals and safety, investor and customer image, or legal matters
important in investment analysis.
 Role of Judgement
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 Vision of judgement of the future plays an important role.

 The opportunities and constraints of selecting a project, its

evaluation of qualitative and quantitative factors, and the
weightage on every bit of pros and cons, cost-benefit analysis, etc.,
are essential elements of judgement.

 Judgement and intuition should definitely be used when a decision

of choice has to be made between two or more, closely beneficial
projects, or when it involves changing the long-term strategy of
the company. For routine matters, liquidity and profits should be
preferred over judgement.

 Judgement plays a very important role in determining the

reliability of figures with the help of qualitative methods as well as
other known financial matters affecting the projects.
 INVESTMENT DECISIONS AND CORPORATE
STRATEGY
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 Strategy provides the decision-maker with a central theme or a

big picture to keep in mind at all times as a guideline for
effectively allocating corporate financial resources.
 As argued by a chief financial officer—Allocating resources to
investments without a sound concept of divisional and
corporate strategy is a lot like throwing darts in a dark room.
 Strategic framework provides a higher-level screening and an
integrating perspective to the whole system of capital
expenditure planning and control. Once strategic questions have
been answered, investment proposals may be subjected to the
DCF evaluation.
 MANAGERIAL FLEXIBILITY AND COMMITMENT
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 Managers consider strategic aspects of investment

projects as crucial for making the investment
decisions.
 Because of uncertainty, managers endeavour to
build flexibility into a capital investment.

 An important question to answer is: How do we

evaluate strategic investments that incorporate
flexibility and commitments?
STRATEGIC REAL OPTIONS
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 Real options are those strategic elements in investments that help

creating flexibility of operations, or that have the potential of
generating profitable opportunities in the future for the firm.
 Real options provide discretion to managers to take certain
investment decisions, without any obligation, for a given price.
 Real options are not confined to real assets only. Patent, R&D,
brands etc. are examples of assets that have a value to the owner.
 The capital investments should be viewed as strategic investments
that incorporate real options. Hence, the value of a capital
investment will also include the value of the strategic elements in
the investment.
 Valuing Real Option
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 An investment with real option consists of two

values: the value of cash flows from the project’s
assets plus the value of any future opportunity
(option) arising from holding the asset.
 We use the Binomial method and Black-Scholes
method of option pricing for valuing real options.
 Types of Real Options
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 Valuing Option to Expand

 Valuing a Patent
 Valuing The Option To Abandon
 Valuing Option to Delay
 Flexibility and Operating Options
 Capital Budgeting Decision-making Levels
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 Forplanning and control purposes, three levels of decision-

making have been identified:
 Operating
 Administrative
 Strategic
 Keeping in view the different decision-making levels,
capital expenditures could be classified in a way, which
would reflect the appropriate managerial efforts to be
placed in planning and controlling them.
 One useful classification could be:
• (i) strategic projects,
• (ii) expansion in the new line of business,
• (iii) general replacement projects,
• (iv) expansion in the existing line of business, and
• (v) statutory required and welfare projects.