Making Management Decisions - Essay Example

NPV and Real options Synopsis The managerial decision making ability rests on the techniques followed in the determination of the feasibility of theprojects. The success of the business depends on the choice of the projects. The NPV is one of the traditional methods followed in measuring the feasibility. However, it does not take into account the risk factors of the project and the market. Therefore, the need for a more suitable method developed which gave rise to the real options theory. This is a more scientific method and takes into account the risks of the projects. Introduction The managerial decision-making is one of the most important points for the success of the projects. The decision making for the managers involve the calculation of the feasibility of the projects. Different methods have been incorporated for the calculation of the feasibility of the projects. The Net Present Value (NPV) is one of the popular methods for measuring the feasibility of the projects. However, there have been alterations in the methods of calculation. New methods have emerged like the real options theory. The paper will deal in the methods, the benefits, and the drawbacks. NPV The calculation of the feasibility of the projects is based on the life and the cash flows of the projects. The NPV is one of the popular traditional methods of measuring the feasibility of the projects. The measurement of the feasibility of the project through the NPV depends on the discounted cash flows and the life of the project. The present value factor is used for the determination of the future cash flows. The discounted cash flows are added to arrive at the present value of the total cash flows. The sum arrived upon is compared with that of the initial cash flow and subtracted. The sum arrived at is the net present value or the NPV of the project. For one project, if the NPV is positive, the project is supposed to be accepted. If there is more than one project to be considered, then the NPVs of all the projects are considered and the project with the highest NPV is chosen. The procedure of the NPV can be described through an example: T NPV =  Ct/ (1+r)t – C0 t-1 T=5; t = 1 to 5 (time period) A project “A” needs a capital outlay of $1,000 and the cash flows for the future are as follows: 2nd year- $500 3rd year- $400 4th year- $300 5th year- $100 The discount rate is 10%. In this case, the cash flows are discounted as follows: 1st year- ($1000) 2nd year- $454.55 3rd year- $330.58 4th year- $225.39 5th year- $68.30 Comparing the cash flows we get a NPV of $78.82. This is the usual practice in the case of more than one project. (Brigham & Ehrhardt, 2008, Pp 380-381) As seen from the above, the NPV is a method, which takes care of the discounting of the cash flows and the time period of the projects. Though the system has been useful in the earlier years, various theorists and practitioners in the financial world have coherently denied the use of the NPV in measuring the feasibility of the projects. The business environment of the modern world is changing and the decisions regarding the future of the projects cannot be determined by the calculation of the cash flows. The cash flows of the business in the future years depend on certain conditions of the environment and the conditions of the business can change. The business should have the flexibility to adapt to the changes of the modern world. Therefore, the need for a method, which takes into account the risk factors of the project, was considered feasible. This gave rise to the real options theory. Real options The real options model in the business is based on the options model in the capital market scenario. In the capital market, the options are the financial assets, which gives the holder the right to buy or sell the essential assets at a particular price and date. Two forms of options exist in the capital market- the call option and the put option. The call option is the “right to purchase” the underlying asset at a specified date and price. The put option is the “right to sell” at an explicit price and date. The holder of the call option and the put option posses the right and not the obligation to purchase and sell. For the call option, if the price of the shares in the market is high then the holder can access his right to purchase the shares in the predetermined price. The opposite happens in the case of put option. In the business scenario, the operations are the same, but the underlying asset is the business. The real options take into account the risk factors of the market. The Black-Scholes model is followed in the case of the real options in the market. (Trigeorgis, 1996, Pp 1-4) This can be stated with an example: A company, “A” is contemplating to invest in a different project “B” in a new country. There are many constraints regarding the market scenarios and the viability in this case. If we take the help of the real options, then we can solve the problem with a slight alteration of the Black-Scholes model.(Appendix 1). Taking into account the figures in the problem we see that the NPV of the project is -$ 500 million whereas, taking the real options it is $ 800 million. (Alleman, 1999; Pp 43-45) The Black Scholes model takes into account the risk of the project and the interest rates. A general assumption is made regarding the value of the project though the value has been found out the by the standard deviation and variance. This helps in negating the risks of the project. Every component of the project like the market size, risk free rate etc. are taken. This puts the value of the project in a better position than that found in the case of NPV. Conclusions From the above illustrations, we can see that the Real options is a better way of calculating the feasibility of the project as it takes into account the risk factors of the market. The NPV does not take into account the market factors and the risks associated with it. The modern business environment is changing and it is necessary for the project to take into account the sensitivity factors. It proves that the process of NPV is flawed and the real options are more scientific. Appendix 1 Value of the real option = V eyt N(d1) - X e-yt N(d2) d1 = [In (V/X) + r – y + (Var/2)t] / S.D. (t) ½ d2 = dt – S.d. (t) 1/2 Where, V = business Value of V = present value of cash flows X = Present value of project’s cash flows t = time of the decision t = Risk free rate Var = Variance of the present value of the cash flows. S.D = Standard Deviation Price Charged = 90% of the market price. Weighted average cost of capital of A = 12.63% Life = 10 years. Market size = 0.3 of current market of A Operating costs = 120% of the present operating costs of A Capital expenditure = 110% of the existing capital expenditure of A. Future cash flows = $ 2.5 billion. Risk free rate= 6.4% References: 1. Brigham, E and Ehrhardt, M. (2008). Financial management: theory and practice. Thomson learning. 2. Alleman, J. (1999). The new investment theory of real options and its implications for telecommunications economics. Kluwer Academic Publishers. 3. Trigeorgis, L. (1996). Real options: managerial flexibility and strategy in resource allocation. Library of Congress. Read More