Monday, December 27, 2010

(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.

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