The Dcf Approach to Capital Budgeting

The DCF approach to capital budgeting the decision rule states that a project with a positive NPV is accepted and one with a negative NPV is rejected, this assumes that the only important decision is the initial one of whether to invest or not. Corporate investments are seldom held static.

When evaluating corporate investment opportunities, management must account for any embedded real options, that is, the right but not the obligation, to take further strategic action at a future date with respect to an underlying asset or investment. Real options can be valued similarly to financial options, and have a value subscribed to them based on the time to expiry and a variability and value of the potential outcomes. Unlike financial options, real options do not have a secondary market that would allow for making to market the true value of the option.

The four main categories of real options are as follows: 1. Expansion and follow on, 2. Timing and delay, 3. abandonment, 4. Flexibility into production.

Decision trees: Are a useful tool to help evaluate options, allow to a better understanding of a project’s risks and rewards by simplifying the investment process into a series of decision points and events together with their respective outcomes.

Example:

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Each circle represents an event node (CF) for that period, the payoff tree of each project occurs over two periods starting in year 0 and ending in year 2, probabilities are assigned to each event.

The first step is to calculate the PV of the weighted average of the probabilities and event values.

The second step is to discount CF1 back to present.

This value must then be compared to the initial investment to determine expected NPV.

The procedure of calculating expected cash flows at a future point in time and discounting back to the previous period is known as rolling back the decision tree.

This example lacked any real options.

This decision trees can be used with options to expand production for example. You should follow the same procedure, calculating the NPV with and without the expansion decision in order to take the more profitable decision.

At a first glance projects with a negative NPV could be considered poor investments, however, an option to enter into a new or follow on project as a result of the initial negative NPV can have tremendous value. Failing to consider an individual project within the context of the overall corporate strategy and future flexibility, management risks overlooking projects that may have long term growth and profitability.

In the case of follow on expansion options, an alternative method can also be used, its characteristics resemble those of a call option on a financial asset. The opportunity to produce and sell the second drug is a call option on the uncertain future cash flows, and can be valued using the black scholes pricing model, it requires 2 more parameters: a measure of variability of the project value and the RFRR to the term from now until the date of the decision to undertake the project.

Timing and delay options:

Delaying a project can also generate value, when the environment is uncertain, delaying the project can allow the investor to see how market will materialize. On the other hand if a project appears to be deteriorating, waiting could result in a lost opportunity. Timing and delay options are the equivalent of owning a call option, this can be evaluated with the same model stated above.

Abandonment options: When evaluating capital budgeting decisions, it assumes an investment lifespan and forecasts, the expected CF to that date. However not all investments run as projected, the option to abandon a project and salvage any remaining asset value can help save the company from further loses. Similar to a put option, exercising and abandonment option is advantageous when the value that could be obtained from the assets is greater than the value of continuing with the project.