Advantages Over Discounted Cash Flow Analysis - Example

Real options Prepared by Submitted to Word count 1758 words (excluding content and reference pages) 1. Introduction The real options valuation is termed as an improved decision making that goes into the project. This is not widely accepted in the recent past, because many project managers worried about the expensive software usage due to the esoteric black scholes equations frequently used. This, in view of them needs a specialist finance expert in the project team. The managers who are familiar with this valuation will use decision tree frame work that best suited to contingencies. This decision tree framework can be used as strategic planning tool and decision analysis. The adoption of real options method is due to the problems that can be posed by NPV. This is because the NPV assumes conditions of low uncertainty. The uncertainty is not enough to contemplate changes in the strategic plan. In net present value, the opportunities are estimated only on the basis of current information and not future analysis is taken into consideration. Generally most of the businesses cannot decide on now or never variety. They plan strategies on the magnitude of uncertainty. The uncertainty also can be taken into consideration while planning strategies. Real option valuation can enable the managers to estimate and react to the risk simultaneously. This can be efficiently used in constant price shifts, fluctuating interest rates and fickle customer tastes due to emerging technologies. Keeping the above situations in view, the Real options valuation can play an important role in developing a strategy. This strategy can guide the managers and the company through the decision making process. 1 2. Advantages of Real Options Analysis The advantages of real options can be termed as those more than the discounted cash flow analysis. In DCF analysis the project’s cash flows are assumed as that are in the onset. This may result in static approach in decision making regarding investments. It needs to be or assumes that all operations are made in advance. In case of real options analysis, the set of available investment projects are taken in order to decide those worth undertaking. The future cash flows can be expected and can be planned to be adjusted at risk adjusted to cost of the capital. This option in real options valuation can help in minimizing the risk regarding cash flows in future. This can prove as an advantage when any company is trying to acquire a property on call option basis or introducing a new product with a breakeven period of 5 to 10 years. In case of acquiring a property, the future value of it can be estimated and utilizing the call option can be analyzed. In case of introducing a new product like napoleon company, the expectations of profits in the future years can be estimated in this context the real options valuation will be useful to take decisions of investments, cost and profit analysis about the future. 2 The real option valuation cannot be termed as a derivative instrument. The advantage of the option is that it is tangible in the sense of choice. The choice is due to the gains that can be made by the business by some endeavors. When a company like napoleon invests in a project, the real option of expanding, selling, downsizing or abandoning the projects and other ones can be estimated and the decisions can be taken according to the flexible budge proposals and even by minimizing the risks. 3 3. Advantages Over Discounted Cash Flow Analysis The advantage of the real options over discounted cash flow analysis lies in the accuracy of estimating the value of corporate investments in the future. In discounted cash flow analysis, the future analysis of the investments is not possible as there is no tool of estimating and taking steps regarding eliminating it. In eliminating the uncertainty, the strategies regarding elimination of risk can be adopted. This is not possible in discounted cash flow analysis, as the future estimations and analysis is not possible. The emerging new economies need to have a perfect future analysis tools. One cannot depend on the conventional fundamentals like discounted cash flow analysis which works on the current information and static budget proposals. These things give an advantage for the real option project analysis over the DCF analysis by estimating the values of the investments and the amounts of profits in future. As the larger investments take a substantial amount of time to breakeven or to establish the product in the market, the future estimations and the strategies regarding the risk elimination are necessary. These are absent in the discounted cash flow analysis and the introduction of the new project prompted the napoleon management to adopt the real option project analysis to estimate the profits and losses in the coming ten years. It was estimated by taking into account, R&D sales, tax rate and WC/Sales as 7.5, 30 and 15 percent respectively. The real options valuation method take into consideration the problems and issues that conventional method do not address. The tools regarding the Strategic thinking, identifying strategic options, priority of strategies and optimizing the timings are present in real option analysis. If not these tools can be adopted and the modern advances in technology can give a software support to the options analysis. Though it may prove costly yet times, it will be useful in eliminating risk and thus minimizing the loss aspect in the future. 4 The net cash flow is estimated from I year’s -410 to 10 th year’s 1490 thousands of pounds and any obstructions can utilize the flexible budget proposals to minimize the probability of loss. In real option analysis, there is an opportunity to use analytical tools for future analysis. They are imputed real options value and project value and investment expenditure. The former allows calculating real options that are implied by the difference between the valuation of the market and the value of the company’s existing businesses. In the latter the potential of the project is calculated. This is to justify the imputed real options value. There is also chance for estimation of the size of the investment expenditure. 1. Introduction The large companies in the past year had changed business technology priorities by opting to real options analysis. The reality of slowing and freezing the long term projects, evaluation of IT projects resulted in utilizing the opportunities in real option analysis. The real option methodology can lead the napoleon company for the futures estimation and the strategies to utilize the initial investments. There is a possibility of reducing the R&D costs if the bags produced are up to the mark within 2 to 3 years of the production. The estimation of the risks regarding the usage of bags to fill them with liquids will result in reducing the R&D costs. This is capable of reducing the cost of goods sold as the cost of the production is decreased and profitability can be enhanced. To work out these methods, the real option analysis will utilize the software technology. The estimation of uncertainty in the marketing of the big bag by the napoleon company can be estimated and the obstructions in attaining the profit and cash flow according to their estimation can be achieved by the flexible budget proposals. The alternative or the opportunity that ensures the napoleon company in real options is to maximize the IT opportunities. These opportunities will not only help in estimating and analyze the future risks and limitations but also be extended to new strategies that involve in the IT in the future. The company can find the possibility to apply its thinking into the projects through IT. 5 The framework that can bridge the gap between the practicalities of real world capital projects and the mathematics associated with formal option pricing theory is available in the real options analysis. The napoleon company can do it in its new project because it involves the costs and profit estimation in the future. As the product’s marketing has not yet been started, the risks and uncertainties involved in it can be estimated and the actions regarding eliminating it can be planned. These above mentioned things are overlooked in the discounted cash flow analysis by the executives. The acceptance of analogy between financial options and corporate investments in research and production of big bag is appealing to accept the real options opportunities. It is difficult to decide about investment on future marketing and production with the help of real option valuating opportunities. The real option analysis proposed by new experts is providing the executive to produce good decisions instead of being too technical. 6 In real options project analysis, the investment opportunities can be taken as real options. This is absent in conventional discounted cash flow analysis and this enables a company like Napoleon plastics company to estimate on the future of the investments. The conventional methods only analyze the results of the methods followed and the future options cannot be termed as real. The real option analysis can be used efficiently by Napoleon Plastic Company as it involves the financial decisions, investment appraisal, asset valuation and performance measurement. As the company is introducing new and innovative products like the bags from 1 liter to 1000 liter capacity, the futuristic performance measurement is necessary as the project needs to estimate the future needs that effect the sales and marketing of the bags positively or negatively. If the estimations are positive, the increase of the profitability can be estimated. If the estimates result in negative, the marketing strategies that increase the sales of the bags by dominating the competitors in the market can be explored using the future options. The exploring the options of patent, brand ownership in the future and the avoidance of the exploitation of the patent by others is needed. This is possible when the patent provisions are best used by the company. This helps in developing the brand name as the company is introducing the product in the company. The situations that make the company to lose the chances of making profit by the lack of strategies of marketing can be explored and strategies can be planned to minimize them. The investment appraisal is possible in the real option analysis. Though it was used by the financial analysts in the investments regarding the portfolio, it can be at its best if the analysis is used in the new investments. The tax rates in future can be estimated and the increase and decrease in the profitability with the expected changes in the tax rate can be estimated. This helps in estimating the cash flow in the future due to the present investment on the manufacturing of big bags by the Napoleon plastic company.7 There is a chance of a better opportunity in real options project analysis, by making IT options as opportunities. This arises from the expected risk by financial analysis in the past regarding implementation of real options analysis. The real options analysis enables the analysts to use IT prudentially and this result in saving of time, though the system is costly. The application of IT not only saves time, but also expedites the analysis and marketing strategies. 8 The inputs needed for the calculations of the real options mentioned are company name, current share price, estimated value of the existing business, shares outstanding in millions, list of options, risk free rate of return, project volatility and estimate of potential project value. In case of new investment like Napoleon plastics there will be two types of uncertainty present. They are economic and technical uncertainties. The former is related with the general movements of the economy and industry. This will incentive the waiting to invest and may lead to post postphone investments. The uncertainty can be estimated using real options analysis and tools. The other one is technical uncertainty. This is not correlated with the general movements of the economy and industry. This depends on the decision process. The napoleon plastics company has estimated the profits before and after tax 10 years in advance and estimated the economic uncertainty to some extent. The technical uncertainty also was estimated by calculating the R&D of the technology at 7.5 percent of the production cost. Thus the technical uncertainty is linked with economic uncertainty and was minimized. References 1. Fabian D' Souza, 2002, Putting Real Options to Work to Improve Project Planning - Project Analysis? Climb the Decision Tree, working knowledge, ,electronic, 12-4-07, http://hbswk.hbs.edu/archive/3090.html 2. Alan Shapiro – C, 2004, Capital Budgeting and Investment Analysis, safari text books online, ,electronic, 12-4-07, http://www.safarix.com/0130660906 3. Media wiki, 2007, Real options analysis, Wikipedia, ,electronic, 12-4-07, http://en.wikipedia.org/wiki/Real_option 4. Johnathan Mun, Real Options Analysis: Tools and Techniques for Valuing Strategic Investment and Decisions, 2nd Edition (Wiley Finance), Amazon.com, , electronic, 12-4-07, http://www.amazon.com/gp/reader/0471747483/ref=sib_dp_pt/002-3849444-0487203#reader-link 5. James Alleman, 2002, real options, real opportunities, optimise, ,electronic, 12-4-07, http://www.optimizemag.com/issue/003/financial.htm 6.Timothy Luehrman, 1998, Investment Opportunities as Real Options: Getting Started on the Numbers, Item detail and ordering, ,electronic, 12-4-07, http://harvardbusinessonline.hbsp.harvard.edu/b02/en/common/item_detail.jhtml?id=98404 7. Sydney Howell and Andrew Stark, 2001, Real Options Evaluating Corporate Investment Opportunities in a Dynamic World, Global investor, ,electronic, 12-4-07, http://books.global-investor.com/books/13831.htm?ginPtrCode=00000&identifier= 8. Alfred Rappaport, 2007, online tutorial, Wikipedia, ,electronic, 16-4-07, http://www.expectationsinvesting.com/tutorial11.shtml 9. Dixit & Pindyck, 1994, real options tutorial, puc-rio.br, ,electronic, 16-4-07, http://www.puc-rio.br/marco.ind/tutor_1.html#Economic%20and%20technical%20uncertainties Read More