options. So, whereas in a DCF valuation themost likelyor average or scenario specificcash
flows are discounted, here the ³flexibile and staged nature´ of the investment ismodelled,and hence "all" potential payoffsare considered. The difference between the two valuations isthe "value of flexibility" inherent in the project.The two most common tools areDecision Tree Analysis(DTA)
andReal options analysis (ROA)
; they may often be used interchangeably:
DTA values flexibility by incorporating
(orstates) and consequent
. (For example, a company would build a factory given that demandfor its product exceeded a certain level during the pilot-phase, andoutsourceproductionotherwise. In turn, given further demand, it would similarly expand the factory, and maintainit otherwise. In a DCF model, by contrast, there is no "branching" - each scenario must bemodelled separately.) In thedecision tree, each management decision in response to an"event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1)"all" possible events and their resultant paths are visible to management; (2) given thisknowledge of the events that could follow, management chooses the actionscorresponding to the highest value pathprobability weighted; (3) then, assumingrational
decision making, this path is taken as representative of project value. SeeDecision theory:Choice under uncertainty.
ROA is usually used when the value of a project is
of some otherasset orunderlying variable. (For example, theviabilityof aminingproject is contingent on
the price of gold; if the price is too low, management will abandon themining rights, if
sufficiently high, management willdeveloptheore body. Again, a DCF valuation would
capture only one of these outcomes.) Here: (1) usingfinancial option theoryas a framework,the decision to be taken is identified as corresponding to either acall optionor aput option;
(2) an appropriate valuation technique is then employed - usually a variant on theBinomialoptions modelor a bespokesimulation model, whileBlack Scholestype formulae are used
less often - seeContingent claim valuation. (3) The "true" value of the project is then theNPV of the "most likely" scenario plus the option value. (Real options in corporate financewere first discussed byStewart Myersin 1977; viewing corporate strategy as a series of options was originally perTimothy Luehrman, in the late 1990s.)
urther information:Sensitivity analysis ,Scenario planning , and Monte Carlo methods in finance
iven theuncertaintyinherent in project forecasting and valuation,
analysts will wish toassess the
of project NPV to the various inputs (i.e. assumptions) to the DCFmodel. In a typicalsensitivity analysisthe analyst will vary one key factor while holding all
other inputs constant,
. The sensitivity of NPV to a change in that factor is thenobserved, and is calculated as a "slope": NPV / factor. For example, the analyst willdetermine NPV at variousgrowth ratesinannual revenueas specified (usually at set
increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using thisformula. Often, several variables may be of interest, and their various combinations produce a"value-surface" (or even a "value-space"), where NPV is then afunction of several variables.
See alsoStress testing.