382 Part 4 Investing in Long-Term Assets: Capital Budgeting
- Experienced managers make many judgmental assessments, including those
related to risk; and they work them into the capital budgeting process.
Introductory students like neat, precise answers; and they want to make
decisions on the basis of calculated NPVs. Experienced managers consider
quantitative NPVs, but they also bring subjective judgment into the deci-
sion process. - If a " rm does not use the types of analyses covered in this book, it will have
trouble. On the other hand, if a " rm tries to quantify everything and let a com-
puter make its decisions, it too will have trouble. Good managers understand
and use the theory of " nance, but they apply it with judgment.
(^9) This section is relatively technical, but it can be omitted without loss of continuity if there is insu$ cient time to
cover it.
(^10) Large investors such as Warren Bu# ett and some hedge fund operators can buy stock in companies and then
in" uence the! rms’ operations and cash " ows. However, the average stockholder does not have such in" uence.
SEL
F^ TEST Is it easier to measure the stand-alone, within-" rm, or beta risk for projects
such as a new delivery truck or a Home Depot warehouse?
If a " rm cannot measure a potential project’s risk with precision, should it
abandon the project? Explain your answer.
12-7 REAL OPTIONS
9
Traditional discounted cash! ow (DCF) analysis—where cash! ows are estimated
and then discounted to obtain the expected NPV—has been the cornerstone of
capital budgeting since the 1950s. However, in recent years, it has been shown that
DCF techniques do not always lead to proper capital budgeting decisions.
DCF techniques were originally developed to value securities such as stocks
and bonds. These are passive investments—once the investment has been made,
most investors can take no actions that in! uence the cash! ow the investment pro-
duces.^10 However, capital budgeting projects are not passive investments—
managers can often take positive actions after the investment has been made that
alter the cash! ow stream. Opportunities for such actions are called real options—
“real” to distinguish them from " nancial options, such as an option to buy shares
of GE stock, and “options” because they offer the right but not the obligation to
take the future action to increase cash! ows. Real options are valuable, but this
value is not captured by conventional NPV analysis. Therefore, a project’s real op-
tions must be considered separately.12-7a Types of Real Options
There are several types of real options, including (1) abandonment, where the proj-
ect can be shut down if its cash! ows are low; (2) timing, where a project can be
delayed until more information about demand and/or costs can be obtained;
(3) expansion, where the project can be expanded if demand turns out to be stron-
ger than expected; (4) output! exibility, where the output can be changed if market
conditions change; and (5) input! exibility, where the inputs used in the productionReal Option
The right but not the
obligation to take some
action in the future.Real Option
The right but not the
obligation to take some
action in the future.