Real Options – Capital Budgeting

REAL OPTIONS – CAPITAL BUDGETING

Sorin R. Straja, Ph.D., FRM Montgomery Investment Technology, Inc. 200 Federal Street Camden, NJ 08103 Phone: (610) 688-8111 sorin.straja@fintools.com www.fintools.com Most investment decisions present the following three characteristics: • Irreversibility: The investment is partially or completely sunk, i.e. it cannot be recovered. • Uncertainty: The best that can be done is to assess the probabilities of the alternative outcomes that can imply larger or smaller profits. • Timing: The decision can be postponed in order to get more information (but never complete information) about future alternatives. The classical theory has not addressed the qualitative and quantitative aspects resulting from the interaction of the above mentioned characteristics. The Marshallian theory computes the ratio between the present value of the profits ( V ) and the present value of the investments ( I ). Whenever this ratio exceeds the unit (i.e. whenever the net present value of the project ( V - I ) is greater than zero), it means the investment should be done. In reality, a firm having to decide about a given investment has an “option” analogous to a call option: it has the right to invest, but it has no obligation to invest. When the firm decides to invest, it makes an irreversible investment expenditure, therefore it exercises, or “kills”, its option to invest. It gives up the possibility of waiting for additional information that might affect the desirability or timing of the expenditure, and it cannot disinvest should market conditions change adversely. This lost option value is a cost that should be included as part of the total cost of investment. Therefore the Marshallian rule should be modified, in the sense that the critical ratio to be exceeded should not be equal to the unit, but greater than the unit. Usually, there is a high degree of uncertainty concerning the present value of the profits, V, while the present value of the...