Introduction to Corporate Finance

11: Risk and Capital Budgeting

We want to emphasise here that, although the numbers are extremely important, they should line up

with experienced intuition. When the two are in conflict, managers need to think hard about whether the

NPV model is in error or whether the project lacks a true competitive advantage.

11- 4b STRATEGIC THINKING AND REAL OPTIONS

We conclude this chapter with a return to the topic of real options. The technical aspects of calculating

the option value of a given financial investment (which we covered in Chapter 8) can be quite complex.

Real options techniques are still relatively new, and are used extensively by companies in only a few

industries. Although we expect an increasing number of companies to include real options analysis as

part of their standard capital budgeting approach, we believe that just thinking about a project from a

real options perspective can be valuable, even if coming up with a dollar value for a real option proves

to be elusive.

Investments generally have option value as long as they are not all-or-nothing bets. Almost all

investments fit this description. Managers usually have opportunities subsequent to the initial investment

to make decisions that can increase or decrease the value of the investment – decisions that create (or

destroy) an investment’s option value. To maximise, or at least recognise, an investment’s option value,

managers should try to describe – before the company commits to an investment – all the subsequent

decisions they will make as events unfold. In other words, managers must articulate their strategy for a

given investment. This strategy may consist of a series of statements like these:

■ If sales in the first year exceed our expectations, then we plan to commit another $50 million to ramp up

production.

■ If consumers enjoy sending and receiving files on their mobile phones, then we will be prepared to invest

additional resources so that our mobile phones will be capable of performing other tasks on the Internet.

■ If our MP3 player cannot hold as many songs as the leading model, then the unit must weigh less than

the market leader or we will not commit the resources necessary to manufacture it.

This series of if ... then statements is necessary to value a real option, but it also has intangible value

in that it forces managers to think through their strategic options before they invest. Identifying a real

option is tantamount to identifying future points at which it may be possible for managers to create and

sustain competitive advantages.

LO11.6

10 Why must manager intuition be part of the investment decision process regardless of a project’s

NPV (or IRR)?

11 Why is it helpful to think about real options when making an investment decision?

CONCEPT REVIEW QUESTIONS 11-4