Corporate Finance

A Real Option’s Perspective of Capital Budgeting 
 247

It does not, for example, consider why managers cannot wait and then invest.

Wait

Cash flows

Investment

If the price for the product turns out to be weak, they may choose to abandon the project or wait for some
time. The DCF methodology does not account for managerial flexibility in making mid-course corrections.
For instance, as pointed out above, the managers of a company mining gold could stop digging if gold prices
fall. The NPV calculated using the DCF methodology is a complex average of many outcomes—both positive
and negative. Managers, of course, have the option to avoid downside by limiting investment. Real options
are options on capital projects implicitly held by companies. Just as a bond–warrant package is to be valued
separately and added up, the option component of capital projects has to be valued separately and added to
the DCF value.
Real Options analysis extends financial option theory to options on real assets. Investment examples
include new plants, line extensions, joint ventures, and licensing agreements. Real options analysis is a com-
plement to DCF analysis, not a substitute. The DCF methodology falls short of real options analysis on
several counts:

• Flexibility is the ability to defer, abandon, expand or contract an investment. Because the NPV rule does
  not factor in the value of uncertainty, it is less robust than real options approach. For instance, a company
  may choose to defer an investment for some period of time until it has more information about the market.
  The NPV rule does not assign value to the investment whereas the real options approach would.


• In standard finance, higher volatility means higher discount rates and lower NPV. In options theory,
  higher volatility leads to higher option value because of asymmetric payoff.


• In many situations future investments are contingent on the success of current investments. Managers
  may make investments today, even if they are negative NPV projects, to access future investment oppor-
  tunities. Pharmaceutical companies are a good example. Future spending on drug development is often
  contingent on the product clearing hurdles. This is valuable because investments can be made in stages,
  rather than up-front.

Capital projects are like options; in the sense that managers have the right but not the obligation to cultivate
them. An R&D investment may, for example, may open up new markets and products. So a valuation of the
R&D investment should take into account the value of future products as well. Likewise while making natural
resource investments (e.g., gold mining) managers may have the option but not the obligation to wait for cer-
tain number of years by paying a fee.
Jeff Bezos, a computer science and electrical engineering graduate from Princeton University founded
Amazon.com in July 1994. Amazon.com opened its doors in 1995 with the mission to become a leader in sell-
ing books online. Initially it offered 10 lac titles. Bezos believes that retail would become the Internet’s most
important application. Although Amazon.com started out with selling books, the same infrastructure could
then be used to sell music cassettes and videos. In other words, Amazon.com holds an option on the second
generation products like music and video. If Amazon.com is successful in selling books on the Internet,
it could expand the product offering to music and video.