(223)---REAL OPTIONS INVESTMENTS

Real Options Investments

Capital expenditure or investment planning and control involve a process of facilitating decisions covering expenditures on long term assets. Since a company’s survival and profitability hinges on capital expenditures, especially the major ones, the importance of the capital budgeting or investment process cannot be over-emphasized. A number of managers think that investment projects have strategic elements, and the investment analysis should be conducted within the overall framework of corporate strategy. Some managers feel that qualitative aspects of investment projects should be given due importance.

Capital investments

Strictly speaking, 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 research and development expenditures are a capital investment. Similarly, the expenditure incurred in acquiring a patent or brand is also a capital investment. In practice, a number of companies follow the traditional definition, covering only expenditures on tangible fixed assets as capital investments. Large expenditures on research and development, advertisement, or employees trading, which tend to create valuable intangible assets, may cannot be included in the definition of capital investments since most of them are allowed to be expended for tax purposes in the year in which they are incurred. From the point of view of sound decision-making, these expenditures should be treated as capital investments and subjected to proper evaluation.

A number of companies follow the accounting convention to prepare asset wise classification of capital expenditures, which is hardly of much use in decision making. Some companies classify capital expenditures in a manner, which could provide useful information for decision making. Their classification is,

1. Replacement
2. Modernization
3. Expansion
4. New project
5. Research and development
6. Diversification
7. Cost reduction

(222)---RISK ANALYSIS IN CAPITAL BUDGETING

Summary Two – Risk analysis in capital budgeting

• Simulation analysis overcomes the limitations of sensitivity or scenario analysis. The analyst specifies probability distributions for variables and computer generates several hundred scenarios, probability distribution for the projects’ net present value along with the expected net present value and standard deviation.
• Yet another technique of resolving risk in capital budgeting, particularly when the sequential decision making is involved, is the decision tree analysis. The decision tree provides a way to represent different possibilities so that we can be sure that the decisions we make today, talking proper account of what we can do in the future.
• To draw the decision tree, branches from points marked with squares are used to denote different possible decisions, and branches from points marked with circles denote different possible outcomes. In a decision tree analysis, one has to work out the best decisions at the second stage before one can choose the best first stage decision.
• Decision trees are variable because they display links between today’s and tomorrow’s decisions. Further, the decision maker explicitly considers various assumptions underlying the decision. The use of decision tree is, however, limited because it can become complicated.
• One important theory, which provides insight into risk handling in capital budgeting, is the utility theory. It aims at including a decision maker’s risk preferences explicitly into the capital expenditure decision. The underlying principle is that an investor prefers a higher return to a lower return, and that each successive identical increment of money is worthless to him than the preceding one. The decision maker’s utility function is derived to determinate the decision’s utility value.
• The direct use of the utility theory in capital budgeting is not common. It is very difficult to specify utility function in practice. Even if it is possible to derive utility function, it does not remain constant over time. Problems are also encountered when decision is taken by group of people. Individuals differ in their risk preferences.

(221)-RISK ANALYSIS IN CAPITAL BUDETING (SUMMARY)

Summary one – Risk analysis in capital budgeting

• Risk arises in the investment evaluation because the forecasts of cash flows can go wrong. Risk can be defined as variability of returns of an investment project. Standard deviation is a commonly used measure of variability.• Statistical techniques are used to measured and incorporate risk in capital budgeting. Two important statistics in this regard are the expected monetary value and standard deviation. The decision maker instead of working with one single forecast can work with a range of values and their associated probabilities. The expected monetary value is the weighted average of returns where probabilities of possible outcomes are used as weights.
• Decision maker in practice may handle risk in conventional ways. For example, they may use a shorter payback period, or use conservative forecasts of cash flows, or discounted net cash flows at the risk adjusted discount rates.
• A more useful technique is the sensitivity analysis. It is a method of analyzing change in the projects net present value for a given change in one variable at a time. It helps in asking what if questions and calculates net present value under different assumptions.
• Scenario analysis is the extension of sensitivity. It considers a few combinations of variables and calculates net present value for each of them. It is a usual practice to calculate net present value for each of them. It is a usual practice to calculate net present value under normal, optimistic pessimistic scenario.
• Sensitivity or scenario analysis forces the decision maker to identify underlying variables, indicates critical variables and helps in strengthening the project by pointing out its weak links. Its limitations are that it cannot handle a large number of interdependent variables and at times, fails to give unambiguous results.

(220)---BENIFITS AND LIMITATIONS OF UTILITY THEORY

Benefits and Limitations of Utility Theory

The utility theory approach to risk analysis in capital budgeting has certain advantages. First, the risk preferences of the decision maker are directly incorporated in the capital budgeting analysis. Second, it facilitates the process of delegating the authority for decision. If it is possible to specify the utility function of the superior- the decision marker, the subordinates can be asked to take risks consistent with the risk preferences of the superior.

The use of utility theory in capital budgeting is not common. It suffers from a few limitations. First, in practice, difficulties are encountered in specifying a utility function. Whose utility function should be used as a guide in making decisions? For small firms, the utility function of the owner or one dominate share holder may be used to guide the decision making process of the firm. Second, even if the owners’ or a dominant share holders’ utility function be used as a guide, the derived utility function at a point of time is valued only for that one point of time. Third, it is quite difficult to specify the utility function if the decision is taken by a group of persons. Individuals differ in their risk preferences. As a result, it is very difficult to derive a consistent utility function for the group.

(219)---UTILITY THEORY AND CAPITAL BUDGETING

Utility Theory and Capital Budgeting

On the basis of figures of the expected values and standard deviations, it is difficult to say whether a decision maker should choose a project with a high expected value and a high standard deviation or a project with a comparatively low expected value and a low standard deviation. The decision makers’ choice would depend upon his risk preference. Individuals and firms differ in their attitudes towards risk. In contrast to the approaches for handling risk, utility theory aims at incorporation of decision makers’ risk preference explicitly into the decision procedure. In fact, a rational decision maker would maximize his utility. Thus, he would accept the investment project, which yields maximum utility to him.

Risk attitude

As regards the attitude of individual investors towards risk, they can be classified in three categories.

• Risk-averse investors attach lower utility to increasing wealth. For them the value of the potential increase in wealth is less than the possible loss from the decrease in wealth. In other words, for a given wealth or return, they prefer less risk to more risk.
• Risk-neutral investors attach same utility to increasing or decreasing wealth. They are indifferent to less or more risk for a given wealth or return.
• Risk-seeking investors attach more utility to the potential of additional wealth to the loss from the possible loss the from the decrease in wealth. For earning a given wealth or return, they are prepared to assume higher risk.
  

It is well established by many empirical studies that individuals are generally risk averts and demonstrate a decreasing marginal utility for money function.