CHAPTER 10 Risk and Refinements in Capital Budgeting 445Spreadsheet Use Comparison of the annualized net present values of
two projects with unequal lives also can be calculated as shown on the
following Excel spreadsheet.Step 3 Reviewing the ANPVs calculated in Step 2, we can see that project X
would be preferred over project Y. Given that projects X and Y are
mutually exclusive, project X would be the recommended project
because it provides the higher annualized net present value.Recognizing Real Options
The procedures described in Chapters 8 and 9 and thus far in this chapter suggest
that to make capital budgeting decisions, we must (1) estimate relevant cash
flows, (2) apply an appropriate decision technique such as NPV or IRR to those
cash flows, and (3) recognize and adjust the decision technique for project risk.
Although this traditional procedure is believed to yield good decisions, a more
strategic approachto these decisions has emerged in recent years. This more
modern view considers anyreal options—opportunities that are embedded in
capital projects (“real,” rather than financial, asset investments) that enable
managers to alter their cash flows and risk in a way that affects project accept-
ability (NPV). Because these opportunities are more likely to exist in, and be
more important to, large “strategic” capital budgeting projects, they are some-
times calledstrategic options.
Some of the more common types of real options—abandonment, flexibility,
growth, and timing—are briefly described in Table 10.4. It should be clear from
their descriptions that each of these types of options could be embedded in areal options
Opportunities that are embedded
in capital projects that enable
managers to alter their cash
flows and risk in a way that
affects project acceptability
(NPV). Also called strategic
options.