M4A1 Discussion Budgeting with Real Options

Capital Budgeting M4A1 Peer Discussion

Peer 1

Budgeting with Real Options

Christopher Copenhaver posted Apr 5, 2018 7:28 PM

Memorandum

 

From: Chris Copenhaver

To: XYZ, Manager

Subject: Budget with Real Options

When you are trying to recognize the profitability of most projects, the success of that project is unknown. There are different approaches that a company can take and many recommendations that a company can utilize. The well-known recommendation is using the NPV method. With the NPV method a company can calculate the project using the cash outflow and inflow for the duration of the project along with the cost of capital. During this, the company can see whether there is going to be a positive NPV, which the company should accept, or a negative NPV and the company should reject. There are other methods that a company can use besides the NPV method. They can use the IRR method, profitability index, and the payback period can also be filtered in to ensure they are making the proper decisions.

A company can also use the real option approach. With this, there are other factors that can be instilled in the findings. Say there are delays in the project, these can be factored into the projects calculations.  Sometimes being able to show the delays can result in people considering this to be a better method. However, this method is a very complex and should only be utilized if the project is large enough, this way results may be shown. Companies tend to go with a project that shows a greater probability success rate than that of an assumed one.

In most cases when a company plays out the scenarios, they are sure that the project they chose will be 100% worth the option of going ahead with and completing the project however, there are sometimes uncertainties and the value beforehand is 0%. A way to look at this is:

Value of real option = the value of knowing the certainty - the value of the results not known.                                                           When this happens, the value with the real options has an increase. When and if this option is not used, the advantage of utilizing this option is not calculated in and it ends up underestimating the NPV. It is beneficial to a company to understand and to determine the usefulness of the value of real option and let it aid them in making their best decision.

 

References

Van Putten, Alexander B. (Dec, 2004). Making Real Options Really Work. Retrieved from https://hbr.org/2004/12/making-real-options-really-work

Mun, Jonathan. (2006). Real Options Analysis versus Traditional DCF Valuation in Layman’s Terms. Retrieved from https://pdfs.semanticscholar.org/2f51/e0e143a4a2c166e0c8b84ff41938d831ab2e.pdf

 

Peer 2

M4A1

Loranda Williams posted Apr 7, 2018 8:05 PM

     MEMO

 

To: LND Enterprise

From: Loranda Williams

Date: 7 April 2018

RE: Real Option Budgeting

 

The real option is not the unique financial instrument, but it allows a company to have genuine selections as well as opportunities for an organization to take advantage as well as a realization of an investment (Investopedia, 2018). The real option may possibly be complicated to estimate and establish (Investopedia, 2018). The real option recognizes the value of being flexible and alternative even though the values cannot be measured (Investopedia, 2018). Investopedia states that “Real options are choices a company’s management makes to expand, change or curtail projects based on changing economic, technological or market conditions. Factoring in real options impacts the valuation of potential investments.”

     When an organization predicts the outcome of the future revenue due to an investment the company underestimated the NPV, therefore, it increases the cash flow of an organization. It more beneficial for an organization to continue to produce the product. The company should not abandon a project especially if the outcome is more than the initial investment of the project.  

     The best capital-budgeting analysis to be used with real-world option is the simulation analysis. I chose this analysis because the real-option basically does the same thing. In Boundless Finance it states “ The commonality in applying option-pricing models for real assets and for financial securities is that the future is uncertain.”  Because of the uncertainty of a market, the real-option can be used to decide whether or not the project should cease by allowing management the flexibility to make a future decision for a business (Boundless Finance, n.d.).

Reference:

Investopedia, (208), Real Options, Retrieved from

https://www.investopedia.com/terms/r/realoption.asp

McDonald, R., L., Real Options and Rules of Thumbs in Capital Budgeting. Retrieved from

http://www.kellogg.northwestern.edu/faculty/mcdonald/htm/realopt.pdf

Boundless Finance, (n.d.), Other Considerations in Capital Budgeting, Retrieved from

https://courses.lumenlearning.com/boundless-finance/chapter/other-considerations-in-capital-

budgeting/