(244)---SUMMARY OF THE REAL OPTIONS, INVESTMENT STRATEGY AND PROCESS

Summary of the Real Options, Investment Strategy and Process

• The most important aspects of the capital budgeting process are identification, evaluation, authorisation and control
• Identification of investment ideas is the most critical aspect of the investment process, and should be guided by the overall strategic considerations of the firm. It needs appropriate managerial focus. Each potential idea should be developed into a project.
• A company should have system for estimating cash flows of projects. A multi-disciplinary team of managers should be assigned the task of developing cash flow estimates.
• Once cash flows have been estimated, projects should be evaluated to determine their profitability. Evaluation criteria chosen should correctly rank the projects.
• Once the projects have been selected they should be monitored and controlled to ensure that they are properly implemented and estimates are realised. Proper authority should exist for capital spending. The top management may supervise critical projects involving large sums of money. The capital spending authority may be delegated subject to adequate control and accountability.
• A company should have a sound capital budgeting and reporting system for this purpose. Based on the comparison of actual and expected performance, projects should be reappraised and remedial action should be taken.
• Companies in practice have a total capital budgeting system including processes for project identification, development, evaluation, authorisation and control. Most companies prepare a capital budget, and integrate it with the overall budgeting system.
• Companies are increasingly using discounted cash flow techniques, but payback remains universally popular for its simplicity and focus on recovery of funds and liquidity.
• In practice, judgement and qualitative factors also play an important role in investment analysis. A number of companies pay more attention to strategy in the overall selection of projects.
• Strategic investments are large-scale expansion or diversification projects, and they involve either by their nature or by managerial actions valuable options. Such options include right to expand, right to abandon, right to delay, right to build new businesses, or right to disinvest or harvest.
• Real options create managerial flexibility and commitment. In principle, they can be valued in the same way as financial options are valued. But in practice, it is difficult to get all input parameters for valuing real options. Since large number of real assets are not trade in the market, it is quite difficult therefore to get information on the value of the underlying assets and the volatility.
• Since real options are valuable, managers must identify them, value them, monitor them and exercise them when it is optimal to do so. Managers generally strive to create flexibility and commitment by building real options into investment projects.

(243)---CAPITAL BUDGETING DECISION MAKING LEVELS

Capital Budgeting Decision Making Levels

For planning and control process, three levels of decision making have been identified:

• Operating capital budgeting
• Administrative capital budgeting
• Strategic capital budgeting

Capital budgeting decisions could be categorized into these three decision levels.

Operating capital budgeting

This may include routine minor expenditures, such as expenditure on office equipment. The lower or the middle level management can easily handle the operating capital budgeting decisions.

Administrative capital budgeting

This involves medium-size investments such as expenditure on expansion of existing line of business. Administrative capital budgeting decisions are semi-structured in nature, and they may also involve some options, such as option to delay. Generally, the senior management is assigned the responsibility of handling these decisions.

Strategic capital budgeting

This involves large investments such as acquisition of a new business or expansion in a new line of business. Strategic investments are unique and unstructured and involve simple or complex options, and they cast a significant influence on the direction and value of the business. Top management, therefore, generally handles such investments.

Keeping the 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:

1. Strategic projects
2. Expansion in the line of business
3. General replacement projects
4. Expansion in the existing line business
5. Statutory required and welfare projects

Further, each of these categories could be sub-classified according to funds required by the projects.

Corporate strategy provides the focal point for the firm’s long run strategic planning. The capital budgeting system, particularly for large strategic projects, is determined in the context of strategic planning and, thus it is a top-down process. Corporate strategy and strategic planning play the most crucial role at the identification and evaluation phases. Operating and administrative capital budgeting decisions can be decided at lower/middle level management within the overall strategic framework and guidelines from top management. The capital budgeting system at lower/middle level will largely be a bottom-up process. It may be noted that external and internal environment provides a context to the company to establish and review its mission’s concerns, and multiple objectives, which, in turn, shape its corporate strategy.

(242)---FLEXIBILITY AND OPERATING OPTIONS

Flexibility and Operating Options

Most firms would like to build flexibility in their investment projects to be able to do several alternative things in different ways. The flexibility built into the investment projects involves a set of options. For example, a power generation company may either build a thermal power plant or a gas power plant or a power plant that could operate on both coal and gas. Building a plant that runs on both coal and gas will be quite expensive, but management will have the flexibility of using either gas or coal depending the fuel prices. The company will gain significantly when the prices of coal and gas are unrelated and vary considerably. The extra cost to create the manufacturing flexibility may be quite valuable to the company.

When company will benefit from the flexibility when it can choose from different raw materials to make the same product or it can use the same material to manufacture different products. Oil refineries and chemical plants quite often face these situations. Operations resulting from flexibility would prove to be very valuable when input or output prices fluctuate enormously. Companies need manufacturing flexibility to maintain their market shares and competitive position in highly fluctuate and unpredictable markets. For example, the quick changes in fashions have made it very difficult for the ready-made garments industry to meet the consumers’ changing demand without the flexibility of changing product-mix quickly. To meet the challenge and to have manufacturing flexibility, a large number of companies have invested heavily in sophisticated computer controlled machines that can easily handle product-mix changes almost instantly.

(241)---TIMING OPTION IN INVESTMENT APPRAISAL

Timing Option in Investment Appraisal

Suppose there is no abandonment option. Should the company reject the project as it has a negative net present value (NPV)? If the company management consider the project as a one time “now or never” opportunity, it will be tempted to reject the project. In fact, the company has the option to wait and see how economic conditions turn out to be in the future. If the economic conditions become favorable in the future, the company can undertake the project. The firms create a call option through its approach of wait and see. Deferring an investment helps the firm to receive useful information about the economic and riskiness of the project. With this information, the firm will be in a much better position to decide about the investment project. The timing options (or options to delay) are highly valuable, particularly those firms that operate in highly dynamic economic and competitive environment.

Example

Suppose The Center for Advanced Professional Studies (CAPS) institute is considering installing a solar system for heating water in hotels for students. The system will cost 25 million $ and it is expected to save electricity expenses at the current electricity rates by 2.1 million $ forever. At a cost of capital of 10%, the value of saving is 2.1/0.1 = 21 million $ and the net present value is 21-25 = -6 million $. Since net present value is negative, the project is unattractive for CAPS. Suppose the electricity rates will fluctuate and the saving may be either 1.2 million $ or 3.50 million $. If the saving are 1.2 million $, then the net present value is 1.2/0.1-25 = -13 million $. The project is unprofitable. On the other hand, if saving turn out to be 3.5 million $, then the net present value is: 3.5/0.1-25 = 10 million $. The project looks very attractive now. What should CAPS management do? Should it reject the project or should it wait and see how the electricity rates change? You may recognize that delaying the investment gives CAPS management a chance to see how the electricity rates behave. If the electricity rates increase, CAPS’s saving will be very high. Delaying the project is like as American option. What is value of this option to CAPS?

Valuing option to delay

In case of a stock option, we must note that a dividend payment before the call option matures reduces the ex-dividend price of the stock and the call option’s payoff at maturity. In then case of a non-dividend paying American call option, it should not be exercised before maturity since it is always more valuable until the maturity. This is not necessarily true is case of dividend paying stock. If dividends payments are vary large, it may be more advantages to the call option holder to exercise the option just before the ex-dividend date. An investment project’s cash flows have the same effect as the payment of dividends on the value of a stock option. The Black-Scholes method, adjusted for the payment of dividends, to value an American call option, but it will not give value of call option exactly. The Binomial method values the American call option more accurately.

(240)---ABANDONMENT OPTION IN INVESTMENT EVALUATION

Abandonment Option in Investment Evaluation

Most investments relating to expansions or diversification's require large amount of funds. Once the decision has been made and funds have been committed, these decisions cannot be reserved without incurring huge losses. When uneconomical investment projects are sold or discarded, it is quite difficult to get a good value. In case of some projects the firm may have to incur substantial dismantling cost. In such projects, which may turn out to be quite unprofitable under adverse economic conditions, the firm may like to have the option to abandon gives flexibility to the firm to exit without much loss.

Example

Chemical company is considering building a new plant to diversify into the production of urea. The company has two proposals with regard to technology. Proposal A is to build a custom designed, integrated plant using the latest technology that produces urea and by-products in the most economical way. A less expensive and less profitable scheme, proposal B, is to build a standard plant for manufacturing urea. If economic conditions turn out to be unprofitable, and the firm wants to exit from the urea business, it will be difficult for the firm to sell the plant built under proposal A, but it may be able to sell the plant built under proposal B because of its low investment cost. The government policy has a major impact on the company’s decision. If the current government policy of imports restrictions and fixing the price of urea equal to the cost plus 12% profit on net worth at 85% capacity continuous, proposal A is the better choice. On the contrary, if the current policy changes and the government allow imports and market-determined urea prices, the company may prefer proposal B now so that it has an option to abandon the project by selling it to a larger player in the urea market. Proposal B has, in effect, a put option attached to it, giving the flexibility to abandon the proposed operation in favor of some other activity.

Valuing the option to abandon

How do we value the option to abandon? Suppose the present value of proposal B is 100 million $ without the abandonment option. If the market conditions turnout to be favorable and demand for urea is high, the value of the project at year one increases by 30% to 130 million $. On the contrary, if the market conditions are unfavorable and demand is low, the projects value declines by 40% to 60 million $. Suppose if chemical company does not want to continue with the project, it can sell it for 80 million $. You can recognize that id demand for urea is law at year 1, and then the project value is 60 million $, and it is beneficial for chemical company to abandon the project and realize 80 million $. The value of option when the company exercises it will be 20 million $. (80 million – 60 million). However, chemical company will continue with the project if demand is high, as the company will loss value by exercising the option.

(239)---GROWTH OPTIONS

Growth Options

In practice managers may accept investment projects that have navigate or significant NPV, but may enable companies to find opportunities to find opportunities in the future that add considerable profitability and value. These projects are said to have Growth Options. examples of Growth Options in clued an initial investment in a new market with the intention to expand later on, investment in research and development to develop possible new technology and product, carrying out an expensive advertisement campaign to push sales, acquisition of a patent to have protected returns acquiring rights over a copper mine, or acquiring a vacant land to develop it in the future. Such investments’ are called strategic since they define the Competitive position of the form. Options to expand are useful for achieving the future growth. Such options allow the firm to make future investments later on if the business conditions are favorable. The advantage of making investment in stages, rather than at once, is that the firm gains knowledge about the project’s true profitability and collects information that may help to unravel uncertainty surrounding the project. Option to expand in the future or make investment in stages provides the manufacturing and marketing flexibility to the firm.

Valuing Patent

Patents give valuable options to firm to achieve growth and create value. Firms, through research and development efforts, can develop technology, products or services and can patent them. A patent allows a firm to have exclusive rights for certain number of years to develop and market a product or service. Thus, patent may be viewed as a call option. A firm will develop the product only if it creates values; that is, the present value of cash inflows exceeds the cost of introducing the product.

(238)---STRATEGIC REAL OPTIONS

Strategic real options

They are a number of investments that may contain elements that could provide valuable opportunities to a firm in the future. Some investments may not be profitable but for the attractive opportunities that they are capable of creating in the future. For example, a chemical company may invest in R & D that may help it to develop new chemical and exploit it to introduce new products in the market. Similarly, a fast moving consumer products company may interest in a brand to leverage sales of it is other products. A fertilizer company may install a small plant to manufacture and sell caprolectum to see the reaction of the market, and scale up the plant in future if demand is high. These opportunities are highly valuable and must be identified future opportunities or flexibility is more valuable than investments without such Strategic elements.

real options are 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. We may clarify that real options are not confined to real assets only. Patent, R & D brands etc are examples of assets that have a value to that owner. The capital investments should be viewed as strategic investments that incorporate real options. Hence the value of capital investments will also include the value of the strategic elements in the investment. Valuing real options is real challenge for managers.

The option pricing theory provides a framework for the valuing Strategic investments. The methods of the valuing real options are the same as the financial options although it is difficult to identify the values of certain inputs in case of real options. An investment with real option consists two values the value of cash flows from the projects assets plus the value of any future opportunity arising form holding the asset. Like in a financial option an exchangeable asset underlies a real option. For an example, the underlying asset in the case of an option to expand is the value added to expansion. The cost of expansion is the exercise price.

Some capital investments have embedded options. Managers must recognize and value these options and exercise them when it is advantages to do so. Of firm can attain flexibility and make commitments by internationally creating a simple option in to investment projects. It can obtain flexibility by creating long positions in call or put options. for example, right to expand or right to enter a new venture in the future at a given price is a long position in call option, and right to abandon or right to liquidate in the future at a given price is a long position in put option. A firm may agree to disinvest or some large investment projects may involve complex options. There may be options on options, or options may be interdependent or mutually exclusive. Managers must play an active role in identifying or creating options, valuing them, monitoring them and using them appropriately to create values for the company.

(237)---STRATEGIC MANAGEMENT IN INVESTMENT

Strategic Management in Investments

Strategic Management has emerged as a systematic approach in properly positioning companies in the complex environment by balancing multiple objectives. In practice, therefore, a comprehensive Capital expenditure planning and, control system will not simply focus on profitability, as assumed by modern Finance theory, but also on growth, competition, balance of products, total risk diversification, and managerial capability and flexibility. there are umpteen examples in the developing countries like India where unprofitable ventures are not divested even by the private sector companies because of there desirability from the point of view of consumer and employees, in particular and society, in general. Such considerations are not at all less important than Profitability since the ultimate survival of companies (and certainly that of management) hangs on them. One must appreciate the dynamics of complex forces influencing resource allocating in practice; it is not simply the use of the most refined DCF techniques.
Certain other practical considerations are as follows.

• Apart from the profitability of the project, other features like its (project's) critical utility in the production of the main product, strategic importance of capturing the new product first, adapting to the changing market environments, have a definite there bearing on investment decisions.
• Take technological their developments play a critical role in guiding investment decisions. Government policies and concessions also have a bearing on these.
• Investment in production equipment is the given top priority among the existing of products and the new project. Capital investment for expansion in existing lines where market potential is proved is given first priority capital investment for buildings, furniture, cars, office equipment etc., is done on the basis of availability of funds and immediate needs.

For problem solving under complexities and the relevance of strategic considerations in investment planning, it also implies that resource allocation is not simply a matter of choosing the most profitable new projects as shown by the DCF analysis. What is being stressed is that the 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.