Quantitative Methods in Capital Budgeting & Real Options Techniques

Thesis submitted for the degree of Master of Science in Management of Business, Innovation & Technology

Supervisor: Prof. Gregory S. Yovanof


Pantazis Houlis
March 2009

Capital budgeting is the decision process that managers use to identify those projects that add to the firm’s value. A firm’s capital budgeting decisions define its strategic direction. Its growth, as well as its ability to sustain a competitive advantage depend upon a constant flow of ideas for new products and services, for ways of making existing products better and for ways to operate at a lower cost. Capital budgeting is the process of evaluating specific investment decisions. These are the decisions that determine a firm’s competitive success in a changing technological and competitive landscape. Several quantitative techniques have been developed to help rank projects and to decide whether they should be accepted for implementation. These techniques are analysed in the prism of evaluating a new product development project. Traditional valuation approaches such as Payback period, NPV, IRR are first addressed with the Discounted Cash Flow model. Subsequently, sensitivity and scenario analysis are applied followed by Monte Carlo Simulation and Decision Tree techniques. Having discussed the limitations of the traditional approaches, Real Options analysis is addressed, taking into account the value of uncertainty in strategic investment decision making. The methodologies employed include closed form models, the binomial lattice method and a stochastic simulation technique utilising a Geometric Brownian Motion model. This framework of capital investment decision making tools is applied to a specific business case, involving a new venture developing a product in the consumer electronics market. With the help of these tools a thorough examination is performed, providing insights into the attractiveness of this business opportunity.

Quantitative Methods in Capital Budgeting and Real Options Techniques


Table of Contents
1. Introduction................................................................................... 4 1.2 Research Problem and Objectives ............................................ 5 1.3 Project Classifications .............................................................. 5 1.4 The Capital Budgeting Process ................................................. 6 2. Case Study Description .................................................................. 8 2.1 “WebPulse” Project .................................................................. 8 2.2 Project Model............................................................................ 9 3. Traditional Valuation Methods..................................................... 13 3.1 Payback Period ....................................................................... 13 3.2 Discounted Cash Flow (DCF) - Net Present Value (NPV) ........ 14 3.3 Internal Rate of Return (IRR) ................................................ 16 3.4 Modified Internal Rate of Return (MIRR)............................... 16 3.5 Profitability Index (PI) ........................................................... 17 4. Risk Analysis Techniques ............................................................. 18 4.1 Sensitivity Analysis................................................................. 18 4.2 Scenario Analysis.................................................................... 20 4.3 Monte Carlo Simulation .......................................................... 21 4.4 Decision Tree Analysis ............................................................ 33 5. Real Options ................................................................................ 35 5.1 Real Options Valuation Approach ........................................... 37 5.2 Timing Option - Decision Tree Method ................................... 38 5.3 Timing Option - Black Scholes Model...................................... 39 5.3 Binomial Lattice – Growth & Abandonment Option................ 42 5.4 Geometric Brownian Motion Simulation Model ...................... 48 6. Conclusions.................................................................................. 51 References ....................................................................................... 54 Appendix.......................................................................................... 55 A.1 Time Value of Money .............................................................. 55 A.2 Estimation of Volatility – Logarithmic Cash Flow Returns Approach ...................................................................................... 56

Quantitative Methods in Capital Budgeting and Real Options Techniques


1. Introduction
Financial management is largely concerned with financing, dividend and investment decisions of the firm. The most widely accepted objective for the firm is to maximize the value of the firm to its owners. Financing decisions deal with the firm’s optimal capital structure in terms of debt and equity. Dividend decisions relate to the form in which returns generated by the firm are passed on to equity-holders. Investment decisions deal with the way funds raised in financial markets are employed in productive activities to achieve the firm’s overall goal; in other words, how much should be invested and what assets should be invested in. The relationship between the firm’s overall goal, financial management and capital budgeting is depicted in Figure 1.1.

Goal of the Firm
Maximize shareholder wealth or value of the firm

Financing Decision

Dividend Decision

Investment Decision

Long-term Investments

Short-term Investments

Capital Budgeting Figure 1.1 Corporate goal, financial management and capital budgeting. Funds are invested in both short-term and long-term assets. Capital budgeting is primarily concerned with sizable investments in log-term assets. These assets may be tangible items such as property, plant or equipment or intangible ones such as new technology, patents or trademarks. Investments in processes such as research, design, development and testing, through which new technology and new products are created, may also be viewed as investments in intangible assets. Irrespective of whether the investments are in tangible or intangible assets, a capital investment project can be distinguished from recurrent expenditures by two features. One is that such projects are significantly large. The other is that they are generally long-lived projects with their benefits or cash flows spreading over many years. Sizable, long-term investments in tangible or intangible assets have long-term consequences. An investment today will determine the firm’s strategic position many years hence. These investments also have a considerable impact on the

Quantitative Methods in Capital Budgeting and Real Options Techniques


organization’s future cash flows and the risk associated with those cash flows. Capital budgeting decisions thus have a long-range impact on the firm’s performance and they are critical to the firm’s success or failure.

1.2 Research Problem and Objectives
The aim of this thesis is to provide an overview of quantitative methods used to assist in strategic investment decision making. How can one choose between several projects? What is the value of a proposed new business endeavour? What are the chances the invested amount will produce multiple returns? Will the capital invested be recouped and when? These are but only of few of the questions managers are faced with when planning their firm’s strategy. The use and mechanics behind these techniques are illustrated through their application in a new product development project – the “WebPulse” case study, where their strengths and limitations are analysed. Opportunities created from uncertainty are revealed using a real options approach. Finally, a methodology framework is provided, covering both traditional techniques and the more recent real options methods.

1.3 Project Classifications
Analysing capital expenditure proposals is not a costless operation. For certain types of projects, a relatively detailed analysis may be warranted, while for others, simpler procedures should be used. Firms generally categorize projects and analyse them accordingly: 1. Replacement: maintenance of business. Replacement of worn-out or damaged equipment is necessary if the firm is to continue in business. The only issues here are (a) should this operation be continued and (b) should we continue to use the same production processes? If the answers are yes, maintenance decisions are normally made without an elaborate decision process. 2. Replacement: cost reduction. These projects lower the costs of labour, materials, and other inputs such as electricity by replacing serviceable but less efficient equipment. These decisions are discretionary and require a detailed analysis. 3. Expansion of existing products or markets. Expenditures to increase output of existing products, or to expand retail outlets or distribution facilities in markets now being served, are included here. These decisions are more complex because they require an explicit forecast of growth in demand, so a more detailed analysis is required. Also, the final decision is generally made at a higher level within the firm. 4. Expansion into new products or markets. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums with delayed paybacks. Invariably, a detailed analysis is required, and the final decision is generally made at the very top – by the board of directors as a part of the firm’s strategic plan.

Quantitative Methods in Capital Budgeting and Real Options Techniques


decision tree analysis and the real options approach are often used. with small ones being treated much like the Category 1 projects described above. 6.5.. For typical investment proposals of a large organisation. Research and development. Expenditures necessary to comply with government orders. Safety and /or environmental projects. 1. or insurance policy terms are called mandatory investments. labour agreements. where the shaded box underpins the focus of this thesis and its relation to the whole process. Instead.4 The Capital Budgeting Process Capital budgeting is a multi-faceted activity.2. the distinctive stages in the capital budgeting process are depicted in the form of a simplified flow chart in Figure 1. Companies often make long-term contractual arrangements to provide products or services to specific customers. and a DCF analysis should be performed before the contract is signed. and they often involve non-revenue-producing projects. Long-term contracts. There may or may not be much up-front investment. How they are handled depends on their size. Quantitative Methods in Capital Budgeting and Real Options Techniques 6 . There are several sequential stages in the process. The expected cash flows from R&D are often too uncertain to warrant a standard discounted cash flow (DCF) analysis. 7. but costs and revenues will accrue over multiple years.

control and review Continue. expand or abandon project Post-implementation audit Figure 1.2 The Capital Budgeting Process Quantitative Methods in Capital Budgeting and Real Options Techniques 7 . judgments and gut feelings Accept/reject decisions on the projects Accept Reject Implementation Facilitation. quantitative analysis. monitoring.Corporate goal Strategic planning Investment opportunities Preliminary screening Financial appraisal. Project evaluation or project analysis Qualitative factor.

and simple to use web tablet accompanied by a complementary user centric web service that will facilitate all user interactions with the Internet and will cover in a cost effective way the user’s. highly mobile computing device that takes advantage of all latest Internet technologies. utilizes wireless communications and operates by direct screen contact MyWeb: A service capable to deliver the content available through the Internet according to predefined preferences & user profiles. Case Study Description A new product development project was chosen in order to illustrate the advantages and limitations of each project valuation technique. The combination of the web tablet plus the user centric web service will take advantage of all latest Internet technologies to provide unmatched service offerings to specific segments of Internet market users. 2. education and communication needs. education and entertainment resources as well as communicate and work using multiple media. The idea: To develop an intuitive. WebPulse: A lightweight. Free Disk Space INTERNET Internet Service Provide WebPulse Preferences Personal Info Customized Content Personalized Desktop USB Stick Content: Informational Educational Entertaining Advertising Other Users MyWeb Collaboration File sharing Content Filtering MyWeb Figure 2. an innovative advertisement method and niche market targeting. information. what will the technologies and the products of the future really look like? The need: Easy and convenient access to personalized information.2.1 WebPulse and MyWeb product and service description Quantitative Methods in Capital Budgeting and Real Options Techniques 8 . The query: As more and more of our life propagates onto the web. The core competence is based on a unique design and simplicity in use with the embedded Google based Operating system.1 “WebPulse” Project The WebPulse and MyWeb products ideas were born when trying to combine a query and an already identified need.

2 Project Model The prerequisite for quantitative valuation analysis of a project is it’s estimation of future cash flows. The workspace required for development and manufacturing will be acquired by buying an existing building for $7. excluding depreciation.000. At the end of that time. It is expected that the unit price will not rise. Quantitative Methods in Capital Budgeting and Real Options Techniques 9 . the building is expected to have a market value of $5. 2. In addition.Change in net operating working capital EBIT (1 – T) + Depreciation . Free cash flow is calculated as follows: Free Cash Flow = Net operating profit after taxes (NOPAT) + Depreciation . whereas the equipment will have a market value of $900. This includes the cost of the fixed assets associated with the project plus any initial investment in net operating working capital (NOWC). Annual project cash flow.000. It is also assumed that an amount of NOWC on hand equal to 10% of the upcoming year’s sales is necessary. It is expected that these costs will rise by 2% each year.000. Variable manufacturing costs are estimated to be $280 per unit. many projects have levels of NOWC that change during the project’s life. while the annual growth in sales will be 15%. such as raw material. The building will fall under the Modified Accelerated Cost Recovery System (MARCS) 39-year class. The projects estimated economic life is four years. For the WebPulse project it is estimated that annual sales would be 38.2.000. some extra cash flow is usually generated from the salvage value of the fixed assets. adjusted for taxes if the assets are not sold at their book value.Gross fixed asset expenditures . while the equipment would fall into the MARCS 5year class. At the end of the project’s life.Gross fixed asset expenditures .000 units if the units were priced at $400 each.950.000. will be $800. Depreciation is added back because it is a noncash expense and also because financing costs (including interest expenses) are not subtracted since they are accounted for when the cash flow is discounted at the cost of capital.000 per year.[∆ Operating current assets – ∆ Operating current liabilities] = Typically. It is estimated that the fixed costs during the year 1 development phase are $500. Any return of net operating working capital not already accounted for in the annual cash flow should also be added in the terminal year cash flow. while the necessary equipment would be purchased for the amount of $3.000. The operating cash flow is the net operating profit after taxes (NOPAT) plus depreciation.000. The tax rate is 40% while the company’s cost of capital is 12%. and fixed overhead costs. cash flow estimation includes the following items: 1. 3. Initial investment outlay. Terminal year cash flow.

000 15. is shown at the bottom in cell E32. defined as the difference between the sale price and the book value. in 5 years $5.2. which were assumed to be $280 per unit. We begin with sales revenues. The third row shows the book value at the end of Year 5.0% 2. found as the expected sale price minus the tax liability or plus the credit. found as the rate times the asset’s depreciable basis.2. and is divided into two sections. When taxes are subtracted. which is the initial cost. the Input Data section. We then deduct fixed operating costs and depreciation to obtain taxable operating income.000 $7.0% 5.400. followed by the expected gain or loss. Figure 2. or NOPAT. First year sales (in units) Growth rate in units sold Net Operating WC / Sales Sales price per unit Variable cost per unit Fixed costs Development Phase Fixed costs Market Launch Building cost (= Depreciable basis) Equipment cost (= Depreciable basis) 38.950. one for the building and one for the equipment. Note.0% 2.1 Input data (Base case) In order to estimate the project’s cash flows.2. we are left with net operating profit after taxes.000.2. Thus. Quantitative Methods in Capital Budgeting and Real Options Techniques 10 .000 from the equipment.000.000.000 WACC Riskfree Rate Tax rate Inflation: growth in sales price Inflation: growth in VC per unit Inflation: growth in fixed costs 12. The final row shows the after-tax cash flow the company expects when it disposes of the asset. Gains and losses are treated as ordinary income. that we are seeking cash flows. In the next five columns the operating cash flows are calculated. The first row in each section gives the yearly depreciation rates as taken from Recovery Allowance Percentage portion of the table. that are equal to the gain or loss times the 40 percent tax rate. found by subtracting the accumulated depreciation from the depreciable basis.000 $900. a model was developed using a Microsoft Excel spreadsheet.2.0% Figure 2. The second row in each section gives the amount of depreciation. -$10.042. from Year 0 to Year 5. depreciation must be added back.000. gains result in tax liabilities. for a total of $6. no units are sold in Year 1 since this year is used to develop the product and set up the manufacturing processes.000 $3. Next.400 from the sale of the building and $612. or EBIT. Figure 2. and losses produce tax credits. The first row shows the estimated market value which is the sales price the company expects to receive when it sells the assets in five years. not capital gains or losses. The cash outlays required at Year 0 are the negative numbers in Column E and their sum.000 $800. provides the basic data used in the analysis. Thus. The following row shows the book values at the end of year 5.A summary of the input data described above is presented in Figure 2. Using the information derived from above. though. the firm expects to net $6.0% 40% 0.3. Therefore. found as the product of units sold and the sales price. not accounting income. the projected cash flows over the project’s life are calculated as presented in Figure 2. we subtract variable costs. Six periods are shown.654. Net Salvage Value in Year 5 estimates the cash flows the firm will realise when it disposes of the assets.1.000 Market value of building in 5 years Market value of equip.1.2 shows the calculation of depreciation over the project’s four-year life. As shown in F9.0% 10% $400 $280 $500.

200.520. there is a positive cash flow of $2. an amount of $1.200 at Year 5 as working capital is sold but not replaced.520.000 is needed in Year 1 as NOWC as shown in cell F24.2 Depreciation and Net Salvage Value Estimations the upcoming year’s sales is needed.Raw materials must be purchased and replenished each year as they are used. Sales increase to $17.000.480. so no NOWC is required in Year 5. It is assumed that an amount of net operating working capital (NOWC) equal to 10% of Figure 2.000 already exist for this purpose.000 in Year 2 as shown in cell G25.520. an investment of $1.000 must be made in Year 1 as shown in cell F25. Since no NOWC existed for this project prior to Year 1. Since $1. Thus. as Quantitative Methods in Capital Budgeting and Real Options Techniques 11 . Thus. When the project’s life ends.000 in Year 3.2.000 of NOWC is needed in Year 2. so $1. the company will receive the “Salvage Cash Flows” as shown in the column for Year 5 in the lower part of the table.600. it will receive cash as estimated earlier. When the company disposes of the building and equipment at the end of Year 5. the net investment would only be $228.654.740. Note that there are no sales after Year 5. Sales in Year 2 are $15.010. the total salvage cash flow amounts to $6.

2. These cash flows constitute a cash flow time line and are used as input to the valuation analysis which follows.3 Projected Net Cash Flows Quantitative Methods in Capital Budgeting and Real Options Techniques 12 . Figure 2. we obtain the net cash flows shown in Row 32.shown in cell J30. When we sum the subtotals.

282.600 plus the Year 2 inflow of $2. 3. the next step in the process is the application of different valuation methods.1.3.93 years as shown in Figure 3. Thus.000 plus the Year 1 cash flow of $1.120. the discounted payback period results in 4. was the first formal method used to evaluate capital budgeting projects.000. resulting in $9.000.1. Exact payback may be calculated as: Payback = Year before full recovery + = 4 + $4. Assuming a Weighted Average Cost of Capital (WACC) of 12%.212/$11.186.357.1. Traditional Valuation Methods Having established the cash flows of the project. defined as the expected number of years required to recover the original investment.543.543.778 = 4.480. At Year 1 the cumulative cash flow is the previous cumulative of -$10. Quantitative Methods in Capital Budgeting and Real Options Techniques 13 . the payback occurred during the forth year. which is similar to the regular payback period except that the expected cash flows are discounted by the project’s cost of capital.1 Pay-Back and Discounted Pay-Back Periods A variant of the regular payback.1. Thus the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows.1 Payback Period The payback period.1. is the discounted payback period.1.600.543. The payback calculation is shown in Figure 3.37 years Unrecovered cost at start of year Cash flow during year Figure 3.2 depicts the cumulated cash flows and discounted cumulated cash flows showing the relevant payback periods as the crossing of the x axis of each curve. Figure 3. Similarly. The cumulative cash flow at t=0 is just the initial cost of -$10.000. We see that by the end of Year 5 the cumulative inflows have more than recovered the outflows. the cumulative for Year 2 is the previous cumulative of -$11.720.600 that is -$11.

the project should be accepted. they do provide information on how long funds will be tied up in a project.000.2 Pay-Back Graphs An important drawback of both the payback and discounted payback methods is that they ignore cash flows that are paid or received after the payback period.. If the NPV is positive.2 Discounted Cash Flow (DCF) .000 Cash Flows $5. 3. the greater the project’s liquidity. If two projects with positive NPVs are mutually exclusive. other things held constant.000 0 1 2 Year Cummulative Cash Flow Cummulative Discounted Cash Flow 3 4 5 Figure 3. while if the NPV is negative.000 $0 -$5.000 -$10.000. Sum these discounted cash flows. 2. Although the payback methods have serious faults as ranking criteria.. discounted at the project’s cost of capital. it should be rejected. since cash flows expected in the distant future are generally riskier than near-term cash flows. The equation for the NPV is: NPV = CF0 + =∑ t =0 n CFn CF1 CF2 + + . Also. 3.000. including all inflows and outflows. Find the present value of each cash flow.1.Pay-Back $10. the payback is often used as an indicator of the project’s riskiness.Net Present Value (NPV) The Net Present Value (NPV) method relies on Discounted Cash Flow (DCF) techniques and is implemented with the following steps: 1. the one with the higher NPV should be chosen. Thus. This sum is defined as the project’s NPV. the shorter the payback period. + 1 2 (1 + r ) (1 + r ) (1 + r ) n CFt (1 + r ) t Quantitative Methods in Capital Budgeting and Real Options Techniques 14 .000.000 -$15.000.

there are several issues that an analyst should be aware of prior to using discounted cash flow models. Quantitative Methods in Capital Budgeting and Real Options Techniques 15 . In such a stochastic world. the actual business environment is highly fluid. A deterministic discounted cash flow model assumes at the outset that all future outcomes are fixed.Where CFt is the expected net cash flow at period t. Since the NPV is positive the project should be accepted.240.1. Applying the above to the Webpulse case yields the results depicted in Figure 3. consistent decision criteria for all projects. and n is its life. If a project has a positive NPV. if a firm takes on a project with a positive NPV. In essence. Same results regardless of risk preferences of investors. Simple to explain to management: “If benefits outweigh the costs. there would be no value in flexibility. then the discounted cash flow model is correctly specified as there would be no fluctuations in business conditions that would change the value of a particular project. Figure 3.. Relatively simple. and if management has the flexibility to make appropriate changes when conditions differ. where NPV equals $451. Not as vulnerable to accounting conventions (depreciation.2. decent level of precision. then there is indeed value in flexibility.). Cash outflows (expenditures such as the cost of buying equipment or building factories) are treated as negative cash flows. etc.1 Net Present Value (NPV) calculation An NPV of zero signifies that the project’s cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return on that capital. then it is generating more cash than is needed to service the debt and to provide the required return to shareholders. widely accepted. The most important aspects include the business reality that risks and uncertainty abound when decisions have to be made and that management has the strategic flexibility to make and change decisions as these uncertainties become known over time. using deterministic models like the discounted cash flow may potentially underestimate the value of a particular project. and economically rational. Factors in the time value of money and risk structures.2. Discounted Cash Flow Advantages include: • • • • • • • Clear. do it!” In reality. However. r is the project’s cost of capital. widely taught. a value that will be underestimated using a discounted cash flow model. inventory valuation. and this excess cash accrues solely to the firm’s stockholders. If this is the case. Therefore. the wealth of the stockholders increases. Quantitative.

3.3 Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is defined as the discount rate that equates the present value of a project’s expected cash inflows to the present value of the project’s costs: PV(Inflows) = PV(Investment costs) or equivalently. the IRR is the rate that forces the NPV to equal zero: CF0 + CFn CF1 CF2 + + . A more improved percentage evaluator than the regular IRR is the Modifed Internal Rate of Return (MIRR) defined as: COF ∑ (1 + r )t t = t =0 n ∑ CIF ⋅ (1 + r ) t =0 t n n −t (1 + MIRR) n Terminal Value = PV of terminal value (1 + MIRR) n PV of costs = Here COF refers to cash outflows (negative numbers). Since the calculated IRR is greater than the WACC (12%). a surplus will remain after paying for the capital. the project should be accepted.10%. + =0 1 2 (1 + IRR) (1 + IRR) (1 + IRR) n n NPV = ∑ t =0 CFt =0 (1 + IRR) t Applying the above to the Webpulse case yields an IRR of 13. The left term is Quantitative Methods in Capital Budgeting and Real Options Techniques 16 . The IRR is considered important as a project valuation method since: 1. if the internal rate of return is less than the cost of capital.. CIF refers to cash inflows (positive numbers). surveys indicate that many executives prefer IRR over NPV. 2. The IRR on a project is its expected rate of return. or the cost of the project. and this surplus will accrue to the firm’s stockholders. Apparently. and r is the cost of capital. Taking on a project whose IRR exceeds its cost of capital increases shareholder’s wealth. since the project is expected to earn more than the cost of capital needed to finance it. On the other hand. managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV. 3. then taking on the project will impose a cost on current stockholders. If the internal rate of return exceeds the cost of the funds used to finance the project. 3..4 Modified Internal Rate of Return (MIRR) In spite strong academic preference of NPV.

04 $11. MIRR assumes that cash flows from all projects are reinvested at the cost of capital. Quantitative Methods in Capital Budgeting and Real Options Techniques 17 . while the regular IRR assumes that the cash flows from each project are reinvested at the project’s own IRR. and CF0 represents the initial cost. assuming that the cash inflows are reinvested at the cost of capital.214 Since the PI value is greater than 1. Applying the above to the Webpulse case yields the results depicted in Figure 3. PI gives an indication of the project’s risk. PI = $11. 3. the calculated MIRR is greater than the WACC (12%).87%.1 MIRR Calculation The modified IRR has a significant advantage over the regular IRR.4.5 Profitability Index (PI) Another method used to evaluate projects is the profitability index (PI) as defined with the following equation: PI = PV of future cash flows = Initial cost ∑ (1 + r ) t =1 n CFt t CF0 Here CFt represents the expected future cash flows. The compounded future value of the cash inflows is also called the terminal value..0. Since. because a high PI means that cash flows could fall quite a bit and the project would still be profitable.simply the present value of the investment outlays when discounted at the cost of capital. the project should be accepted. based on a cost of capital of 12%. where MIRR equals = 1. and the numerator of the right term is the compounded future value of the inflows. Figure 3. is 1. Since reinvestment at the cost of capital is generally more correct. The PI for the WebPulse case . or the present value per dollar of initial cost. The PI shows the relative profitability of any project.829.1. The discount rate that forces the present value of the terminal value to equal the present value of the costs ifs defined as the MIRR. again. the project should be accepted. Like the IRR. the modified IRR is a better indicator of a project’s true profitability.378.

that the resultant cash flows rely on the value of the inputs which in reality are not certain. We must recall.2. Then each variable is changed by several percentage points above and below the expected value. We also know that a change in a key input variable. which is developed using the expected values for each input.1. Figure 4. The starting point in analyzing a project’s risk involves determining the uncertainty inherent in its cash flows.1 are then plotted as in Figure 4. though.2. all related valuation techniques are applied on a deterministic model of the project’s cash flows. For the WebPulse case. This uncertainty in input variables translates to risks in the project’s outcomes. also presented as a certainty with no possible variance or margin of error associated with it.1.1 is the base-case NPV.1. It is implied that these cash flows will occur with certainty and it is assumed at the outset that all future outcomes are fixed. Figure 4. Sensitivity analysis begins with a base-case situation. will cause the NPV to change. The outcome of the project is.1 Sensitivity Analysis Intuitively we know that many of the variables that determine a project’s cash flows could turn out to be different from the values used in the analysis. such as units sold.1 are all most likely or base-case values and the resulting $451.240 NPV shown in Figure 3.1 NPV outcomes from sensitivity analysis The values of Figure 4.4.1. other things held constant.1 summarizes the NPV outcomes at different deviations for the base case of each selected input variable. the values of the variables show in Figure 2.2 which shows the WebPulse project sensitivity for six of the input variables. Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable. therefore. 4. Risk Analysis Techniques Up until this point in the analysis procedure. Quantitative Methods in Capital Budgeting and Real Options Techniques 18 . The following analysis techniques take into consideration these uncertainties. Then a new NPV is calculated using each of these values. holding all other variables constant.

000.000 -$8. fairly sensitive to changes in “year 1 units sold” and WACC. -$10.000 $4.3 Sensitivity analysis outlay for tornado diagram plotting Quantitative Methods in Capital Budgeting and Real Options Techniques 19 .000.1. The steeper the slope.1 are presented in Figure 4.000 $10. the more sensitive the NPV is to a change in the variable.000 -30% -15% 0% 15% $0 30% -$2.000 -$6. The same results of Figure 4.000.000 -$4.000.2 Sensitivity Analysis The slopes of the lines in the graph show how sensitive NPV is to changes in each of the inputs.000 Deviation from Base Case Value (%) NPV ($) Variable Cost / Unit Year 1 Units Sold Sales Price / Unit WACC Fixed Cost Growth rate Figure 4. Figure 4.000 $ $6.Sensitivity Analysis $12. From the plots and the table values we see that the project’s NPV is very sensitive to changes in the sales price per unit and variable cost per unit.000 $8. Another way to view the results of sensitivity analysis is with the “tornado diagram”.000.3 but arranged in descending order based on the range of potential outcomes which are indications of the variable’s sensitivities.000.000. and not very sensitive to changes in either Growth Rate or Fixed Cost.000.

2 Scenario Analysis Scenario analysis remedies one of the shortcomings of sensitivity analysis by allowing the simultaneous change of values for a number of key project variables thereby constructing an alternative scenario for the project. high year1 units sold and low WACC will result in a very high NPV.2.1.4 Tornado Diagram 4.Figure 4.2. Figure 4. then the NPV would be -$12 million. low production cost. Quantitative Methods in Capital Budgeting and Real Options Techniques 20 . $27 million. Pessimistic and optimistic scenarios are usually presented. The best-case. However if things turn out badly.1. along with a plot of the data.1 Scenario Analysis If the product is highly successful. then the combination of a high sales price. base-case and worst-case values for the WebPulse project are shown in Figure 4.

3 Monte Carlo Simulation Sensitivity and scenario analyses compensate to a large extent for the analytical limitation of having to confine a host of possibilities into single numbers. For the WebPulse case: CV NPV = σ NPV E ( NPV ) = 3. However useful though.69 which confirms the project’s riskiness since the CVNPV is much larger than 1. 4. Expected NPV = ∑ Pi ⋅ ( NPVi ) = $3. the Microsoft Excel spreadsheet add-on “Simtools (3. and to calculate in a consistent manner its possible impact on the expected return of the project. it is limited in that it considers only a few discrete outcomes (NPVs). by multiplying each possible scenario outcome (NPVi) by its probability of occurrence (Pi) and then summing these products. Monte Carlo simulation adds the dimension of dynamic analysis to project evaluation by making it possible to build up random scenarios which are consistent with the analyst's key assumptions about risk. both tests are static and rather arbitrary in their nature. While Monte Carlo simulation is considerably more complex than scenario analysis.The graph shows a very wide range of possibilities. For the needs of this thesis.933. However. be it in the form of objective data or expert opinion. to quantitatively describe the uncertainty surrounding the key project variables as probability distributions.523. Scenario analysis provides useful information about a project’s stand-alone risk. simulation software packages make this process manageable.275 i =1 n The standard deviation of the project is calculated as follows: σ NPV = ∑ P ⋅ ( NPV i =1 i n i − Expected NPV ) 2 = $14. The term Monte Carlo Method was coined in the 1940s by physicists working on nuclear weapons projects in the Los Alamos National Laboratory. A risk analysis application utilises a wealth of information. and was so named because it utilized the mathematics of casino gambling. indicating that this is indeed a very risky project. the lower the coefficient of variation the less the project risk. even though there are an infinite number of possibilities. Assuming a positive expected value.699 A project’s coefficient of variation is defined as the standard deviation of the projected returns divided by the expected value. The use of risk analysis in investment appraisal carries sensitivity and scenario analyses through to their logical evolution.31)” developed at the Quantitative Methods in Capital Budgeting and Real Options Techniques 21 . The expected NPV results from the weighted average of outcomes.

The Monte Carlo simulation method is a technique by which a mathematical model is subjected to a number of simulation runs. however be no more difficult than the assignment of a single-value best estimate. if a thoughtful assessment of the single-value estimate has taken place. a range of possible values for each risk variable is defined which sets boundaries around the value that a projected variable may assume. The output of a Monte Carlo simulation is not a single-value but a probability distribution of all possible expected returns. it should be quite possible to include the true value within the limits of a sufficiently wide probability distribution. The results are collected and analysed statistically so as to arrive at a probability distribution of the potential outcomes of the project and to estimate various measures of project risk. Defining Input Variable Probability Distributions In defining the uncertainty encompassing a given project variable one should widen the uncertainty margins to account for the lack of sufficient data or the inherent errors contained in the base data used in making the prediction. most of the preparatory work for setting range limits for a probability distribution for that variable must have already been done. The definition of value range limits for project variables may seem to be a difficult task to those applying risk analysis for the first time. The simulation is controlled so that the random selection of values from the specified probability distributions does not violate the existence of known or suspected correlation relationships among the project variables. Myerson was used. the probable values that a project variable may take still have to be considered. successive scenarios are built up using input values for the project's key uncertain variables which are selected from multi-value probability distributions. Setting range limits The level of variation possible for each identified risk variable is specified through the setting of limits (minimum and maximum values). In deterministic appraisal. While it is almost impossible to forecast accurately the actual value that a variable may assume sometime in the future. Quantitative Methods in Capital Budgeting and Real Options Techniques 22 . Northwestern University.Kellogg Graduate School of Management. before selecting one to use as an input in the appraisal. Therefore.B. Although we refer to these two stages in turn. The analyst should make use of the available data and expert opinion to define a range of values and probabilities that are capable of capturing the outcome of the future event in question. The prospective investor is therefore provided with a complete risk/return profile of the project showing all the possible outcomes that could result from the decision to stake his money on a particular investment project. it must be emphasised that in practice the definition of a probability distribution is an iterative process. In practice. The preparation of a probability distribution for the selected project variable involves setting up a range of values and allocating probability weights to it. Range values are specified having in mind a particular probability profile. the problem faced in attempting to define probability distributions for risk analysis subsequently to the completion of a base case scenario is the realisation that not sufficient thought and research has gone into the single-value estimate in the first place. by R. Thus. It should. while the definition of a range of values for a risk variable often influences the decision regarding the allocation of probability. During the simulation process.

It is usually necessary to rely on judgement and subjective factors for determining the most likely values of a project appraisal variable. This may be derived by grouping the number of occurrences of each outcome at consecutive value intervals. Figure 4. however. Quantitative Methods in Capital Budgeting and Real Options Techniques 23 . or to afford the cost of purchasing. quantitative information which will enable the definition of range values and the allocation of probability weights for a risk variable on totally objective criteria. it may be better to opt for the widest range limits mentioned. For example. In such a situation the method suggested is to survey the opinion of experts (or in the absence of experts. looking at historical observations of an event it is possible to organise the information in the form of a frequency distribution. the definition of range limits for project variables is a simple process of processing the data to arrive at a probability distribution.When data are available.1. The analyst should attempt to gather responses to the question “what values are considered to be the highest and lowest possible for a given risk variable?” If the probability distribution to be attached to the set range of values (see allocating probability below) is one which concentrates probability towards the middle values of the range (for example the normal probability distribution). the probability distribution to be used is one that allocates probability evenly across the range limits considered (for instance the uniform probability distribution) then the most likely or even one of the more narrow range limits considered may be more appropriate. It should be apparent.3. that the decision on the definition of a range of values is not independent of the decision regarding the allocation of probability. This process is illustrated in Figure 4.3. He should be able to understand and justify the choices made. The probability distribution in such a case is the frequency distribution itself with frequencies expressed in relative rather than absolute terms (values ranging from 0 to 1 where the total sum must be equal to 1). on the other hand.1 From a frequency to a probability distribution It is seldom possible to have. In the final analysis the definition of range limits rests on the good judgement of the analyst. If. of people who can have some intelligible feel of the subject).

2 Forecasting the outcome of a future event: single-value estimate In assessing the data available for a project variable. Hence. not because risk analysis is being applied. the analyst is constrained to selecting only one out of the many outcomes possible. It is called the deterministic probability distribution and is one that assigns all probability to a single value. the average. The fact that Monte Carlo analysis uses multivalue instead of deterministic probability distributions for the risk variables to feed the appraisal model with the data is what distinguishes the simulation from the deterministic (or conventional) approach to project evaluation. conventional project evaluation is sometimes referred to as deterministic analysis.. as illustrated in the example in Figure 4.3. The need to employ probability distributions stems from the fact that an attempt is being made to forecast a future event.3.2. or to calculate a summary measure (be it the mode. Figure 4. Conventional investment appraisal uses one particular type of probability distribution for all the project variables included in the appraisal model. The assumption then has to be made that the selected value is certain to occur (assigning a probability of 1 to the chosen singlevalue best estimate). Some of the probability distributions used in the application of Monte Carlo analysis are illustrated in Figure 4.3. the result of the appraisal model can be determined in one calculation (or one simulation run). Since this probability distribution has only one outcome. information contained within multi-value probability distributions is utilised.Allocating probability Each value within the defined range limits has an equal chance of occurrence. or just a conservative estimate). Probability distributions are used to regulate the likelihood of a selection of values within the defined ranges.3. Quantitative Methods in Capital Budgeting and Real Options Techniques 24 . In the application of Monte Carlo analysis.

4. People who have this expertise are usually in a position to judge which one of these devices best expresses their knowledge about the subject.3.3 Multi-value probability distributions The allocation of probability weights to values within the minimum and maximum range limits involves the selection of a suitable probability distribution profile or the specific attachment of probability weights to values (or intervals within the range).3. Figure 4. four key variables were chosen to specify their distributions.3. Applying the above to the WebPulse project case.Figure 4.4 Monte Carlo Simulation Input Variables Quantitative Methods in Capital Budgeting and Real Options Techniques 25 . Probability distributions are used to express quantitatively the beliefs and expectations of experts regarding the outcome of a particular future event. as defined in Figure 4.

3.3. Quantitative Methods in Capital Budgeting and Real Options Techniques 26 .7 selected results from the simulation.3.6 the NPV’s cumulative probability graph and Figure 4.5 also depicts the resultant NPV Distribution. while Figure 4.3.5 shows a sample of the 1000 scenarios and consequently simulation runs performed using the Monte Carlo Simulation Software and the project’s model.3.Figure 4.5 Simulation Outcomes and NPV Distribution Figure 4. Figure 4.

3. 00 0 0. 0 0 8.400 0. 00 12 0 .000 -$ 14 . Comparing the simulation results of Figure 4. the range of outcomes is quite large.10% chance that the expected NPV will be positive.200 0.0 $8 . 00 0. the first thing to do is to ensure that the results are consistent with the assumptions. $1 4.100 0. Figure 4.0 0 0. -$ 00 6.0 -$ 00.0 $6 00 . The table also reports that there is only a 52. and this is consistent with this wide range of possible outcomes. -$ 00 2.000 0.0 -$ 00 8. 00 0 0. 0 $0 00 $4 . 00 0 0.3. 00 0 $1 0.7 also reports summary statistics for the project’s NPV. -$ 00 4.300 0.0 00 -$ 10 .00 0 .15 for the coefficient of variation which is very high.600 0.900 0.891. from a loss of -$12.700 0.3.3. 00 0 $1 0.1.422 to a gain of $24.788. The mean is $471. 00 0 . 0 0 6.0 00 .800 0.7 with the input variable distribution definitions of Figure 4. The standard deviation of $4. 00 0 0. However.6 Cumulative Probability Graph Figure 4.500 0.0 00 .7 Summary of simulation results Having completed the simulation.160 indicates that losses could easily occur. 00 0 $2 . This is also reflected with the value of 10. 000 00 $1 0.603.0 00 . 0 0 2. so the project is clearly risky.3.4 it can be concluded that the results are indeed consistent.697. Quantitative Methods in Capital Budgeting and Real Options Techniques 27 . 0 00 0 $1 0.631 which suggests that the project should be accepted. 00 0 0. 00 0 Probability NPV Figure 4.

In other words. In the scenario analysis. In every case examined both the cumulative and non-cumulative probability distributions are illustrated for comparison purposes. respectively.the risk/return profile . provided that it is positive. The expected value of the probability distribution of NPVs (see Measures of risk below) generated using the same discount rate as the one used in conventional appraisal is a summary indicator of the project worth which is directly comparable (and should indeed be similar to) the NPV figure arrived at in the deterministic appraisal of the same project. because risk analysis presents the decision maker with an additional aspect of the project . The independence of variables in the simulation reduces the range of outcomes. simulation may provide a better estimate of project risk. investment decision criteria normally used in deterministic analysis maintain their validity and comparability. when choosing among alternative (mutually exclusive) projects. we implicitly assumed that all of the risky variables were perfectly positively correlated. The final decision is therefore subjective and rests to a large extent on the investor's attitudes towards risk. assuming “rational” behaviour on behalf of the decision maker the following cases may be examined. For example. However. The general rule is to choose the project with the probability distribution of return that best suits one's own personal predisposition towards risk. The “risk-lover” will most likely choose to invest in projects with relatively high return. if the standard deviation and correlations used as inputs in the simulation are not estimated accurately. By using a discount rate that allows for risk. In the scenario analysis. 2 and 3 involve the decision criterion to invest in a single project. then the simulation output will likewise be inaccurate.Note that the standard deviation of NPV in the simulation is much smaller than the standard deviation in the scenario analysis. Decision Criteria The basic decision rule for a project appraisal using certainty equivalent values as inputs and discounted at a rate adjusted for risk is simply to accept or reject the project depending on whether its NPV is positive or negative. showing less concern in the risk involved. in the simulation. the decision rule is to select the one with the highest NPV. However. The “risk-averter” will most likely choose to invest in projects with relatively modest but rather safe returns. Cases 4 and 5 relate to investment decision criteria for choosing between alternative (mutually exclusive) projects. In the simulation it was assumed that the variables were independent. The cumulative probability distribution of the project returns is more useful for decisions involving alternative Quantitative Methods in Capital Budgeting and Real Options Techniques 28 . Through the expected value of the NPV distribution therefore the decision criteria of investment appraisal still maintain their applicability. sometimes the sales price is high. it was assumed that all of the poor outcomes would occur together in the worst-case scenario and all of the positive outcomes would occur together in the best-case scenario. Cases 1.the investment decision may be revised accordingly. Investment criteria for a distribution of NPVs generated through the application of Monte Carlo analysis are not always as clear-cut as this. a high sales price is always coupled with high growth. Similarly. Because the scenario analysis’s assumption of perfect correlation is unlikely. but the sales growth is low. However.

8).3.projects while the non-cumulative distribution is better for indicating the mode of the distribution and for understanding concepts related to expected value. Figure 4.3. The project shows some probability of being positive as well as some probability of being negative. Case 2: The maximum point of the probability distribution of project return is lower than zero NPV (Figure 4. Case 1: The minimum point of the probability distribution of project return is higher than zero NPV (Figure 4.9).10).3.9 Case 2: Probability of positive NPV=0 Case 3: The maximum point of the probability distribution of project return is higher and the minimum point is lower than zero Net Present Value (the curve intersects the point of zero NPV .3. Quantitative Methods in Capital Budgeting and Real Options Techniques 29 .8 Case 1: Probability of negative NPV=0 Since the project shows a positive NPV even under the “worst” of cases (i. Since the project shows a negative NPV even under the “best” of cases (no probability for positive return) then clearly the project should be rejected. therefore the decision rests on the risk predisposition of the investor. no probability for negative return) then clearly the project should be accepted.e. Figure 4.Figure 4.3.

11). the return of project B is always higher than the return of project A. Therefore. Risk “lovers” will be attracted by the possibility of higher return and therefore will be inclined to choose project A. Case 5: Intersecting cumulative probability distributions of project return for mutually exclusive projects (Figure Case 4: Mutually exclusive projects (given the same probability one project always shows a high return) Given the same probability.12). Case 4: Non-intersecting cumulative probability distributions of project return for Table 4. we can deduce the first rule for choosing between alternative projects with risk analysis as: Rule 1: If the cumulative probability distributions of the return of two mutually exclusive projects do not intersect at any point then always choose the project whose probability distribution curve is farther to the right.3.Figure 4. Alternatively. given one particular return. Quantitative Methods in Capital Budgeting and Real Options Techniques 30 . the probability that it will be achieved or exceeded is always higher by project B than it is by project A.10 Case 3: Probability of zero NPV > 0 and < 1 mutually exclusive projects (Figure 4.3. Risk “averters” will be attracted by the possibility of low loss and will therefore be inclined to choose project B.

Rule 2: If the cumulative probability distributions of the return of two mutually exclusive projects intersect at any point then the decision rests on the risk predisposition of the investor. As a general rule one should postpone the investment decision if the possible reduction in the cost of uncertainty is greater than the cost of securing more information (including foregone profits if the project is delayed).13 by the sum of the possible positive NPVs weighted by their respective probabilities. one can decide on whether it is worthwhile to postpone a decision to accept or reject a project and seek further information or whether to make the decision immediately. is a useful concept that helps determine the maximum amount of money one should be prepared to pay to obtain information in order to reduce project uncertainty. indicated in the left-hand diagram. This may be defined as the expected value of the possible gains foregone following a decision to reject a project. Figure 4.12 Case 5: Mutually exclusive projects (high return vs.3. is the sum of all the possible negative NPVs weighted by their respective probabilities. Similarly. Cost of Uncertainty The cost of uncertainty. or the value of information as it is sometimes called.3. By being able to estimate the expected benefit that is likely to result from the purchase of more information. The expected gain forgone from rejecting a project is illustrated in the right-hand diagram of Figure 4. the expected loss from accepting a project. low loss) With non-cumulative probability distributions a true intersection is harder to detect because probability is represented spatially by the total area under each curve. or the expected value of the losses that may be incurred following a decision to accept a project. Quantitative Methods in Capital Budgeting and Real Options Techniques 31 .

13 Cost of Uncertainty Expected Loss Ratio The expected loss ratio (el) is a measure indicating the magnitude of expected loss relative to the project's overall expected NPV. However. This is expressed in the formula absolute value of expected loss divided by the sum of expected gain and absolute value of expected loss: el = Expected Loss Expected Gain + Expected Loss It can vary from 0. On the other hand. A project with a probability distribution of returns totally above the zero NPV mark would compute an el value of 0.Figure 4. a project with a probability distribution of returns completely below the zero NPV mark would result in an el of 1. The ratio does not therefore distinguish between levels of risk for totally positive or totally negative distributions.14).3. to 1.3. within these two extreme boundaries the el ratio could be a useful measure for summarising the level of risk to which a project may be subjected. which means no expected gain. meaning that the project is completely unexposed to risk. this is the probability weighted return derived from the shaded area to the left of zero NPV divided by the probability weighted return derived from the total distribution whereby the negative returns are taken as positive (see Figure 4. meaning that the project is totally exposed to risk. meaning no expected loss. Diagrammatically. Quantitative Methods in Capital Budgeting and Real Options Techniques 32 . The el ratio defines risk to be a factor of both the shape and the position of the probability distribution of returns in relation to the “cut-off” mark of zero NPV.

the focus was primarily on techniques for estimating a project’s stand-alone risk.4 Decision Tree Analysis Up to this point. This reduces risk by giving managers the opportunity to re-evaluate decisions using new information Quantitative Methods in Capital Budgeting and Real Options Techniques 33 . sometimes projects can be structured so that expenditures do not have to be made all at one time. since there are high chances of possible loss but also equal chances of even higher returns.15. For example. the calculated measures of cost of uncertainty and expected loss ratio are shown in figure 4.3. managers are generally more interested in reducing risk than in measuring it.3. rather.3. can be made in stages over a period of years.14 Expected Loss Ratio For the WebPulse project case. but. with the decision of choosing to implement depending on the risk behaviour of the decision maker.15 Simulation results – cost of uncertainty & expected loss ratio Based on the results of the Monte Carlo simulation it seems that the WebPulse project is risky. 4.Figure 4. Figure 4. Although this is an integral part of capital budgeting.

400.000 to design and build a product prototype.1 shows different stages the WebPulse project could be broken down: Figure 4. Based on the expectations set forth in Figure 4. a 50% change of medium market acceptance and a 25% of low market acceptance.4. the project would generate either high. then at t=2 proceed with the construction of a manufacturing plant for a cost of $10. indicating that the project should be cancelled after Stage 1. Stage 2: If it appears that a sizable market does exist. The prototype will then be evaluated in order to determine the continuation of the project. Stage 3: If the prototype proves acceptable.1 and a cost of capital of 12%. If this stage were reached.4. the project’s expected NPV is $629. The column of joint probabilities in Figure 4. medium. then $500. there is a 25% change of high market acceptance and net cash flows will be high. Each joint probability is obtained by multiplying together all probabilities on a particular branch. Figure 4.4. much smaller than the results from the scenario analysis and Monte Carlo simulation indicating that the flexibility for decision making during the course of the project results in not only higher expected project value.216.1 Decision Tree Analysis Stage 1: At t=0. If the project goes into production phase.000 for the initial marketing study and it will be a loss.326 and the resultant coefficient of variation 2. Quantitative Methods in Capital Budgeting and Real Options Techniques 34 .34.and then either investing additional funds or terminating the project.000 study of the market potential for the WebPulse project. followed by the product of the NPV for each branch times the joint probability of that branch. If the marketing study yields positive results. or low net cash flow over the following four years.472. the cost will be the $70. hence of each NPV. and the sum of these products is the project’s expected NPV. then at t=1 spend $500. in which case the project will be terminated. the standard deviation $1. Each branch of the decision tree has an estimated probability of occurrence. but also lower risk.000 will be spent on design and prototyping with a 60% chance that the prototype will be successful and a 40% of a failure.4. At the end of stage 1 there is an estimated 80% chance that the market study will yield positive results and a 20% chance that the study will produce negative results. The NPV for each branch is then calculated. I the project is cancelled. conduct a $70.1 gives the probability of occurrence of each branch. Such projects can be evaluated using decision trees.000.

managers must try to view their markets in terms of the source. determine the degree of exposure for their investments (how external events translate into profits and losses). Value Real Options View Managerial Options Increase Value Traditional View Uncertainty Figure 5. Real Options The traditional discounted cash flow approach in capital budgeting assumes a single decision pathway with fixed outcomes. the real options approach is the extension of financial option theory to options on real (nonfinancial) assets. The real options approach considers multiple decision pathways as a consequence of high uncertainty coupled with management’s flexibility in choosing the optimal strategies or options along the way when new information becomes available. while real options assume a multidimensional dynamic series of decisions. trend and evolution of uncertainty.1 illustrates one of the most important shifts in thinking from the real options approach: Uncertainty creates opportunities. Figure 5. Moving from financial options to real options requires a way of thinking. Many strategic investments create subsequent opportunities that may be taken. In a narrow sense. where management has the flexibility to adapt given a change in the business environment. but not the obligation. While financial options are detailed in the contract. Managers should welcome. In rethinking strategic investments.1 Uncertainty Increases Value Quantitative Methods in Capital Budgeting and Real Options Techniques 35 . to take an action in the future. one option contract traded on the financial exchanges gives the buyer the opportunity to buy a stock at a specified price on a specified date and will be exercised only if the price of the stock on that date exceeds the specified price. For example. and all decisions are made in the beginning without the ability to change and develop over time. real options embedded in strategic investments must be identified and specified. and so the investment opportunity can be viewed as a stream of cash flow plus a set of options. Options are valuable when there is uncertainty. As information becomes available and uncertainty becomes resolved. not fear uncertainty. management can choose the best strategies to implement. management has the flexibility to make midcourse strategy corrections when there is uncertainty involved in the future. one that brings the discipline of the financial markets to internal strategic investment decisions.5. What is an Option? An option is the right. Traditional discounted cash flow assumes a single static decision. and then respond by positioning the investments to best take advantage of uncertainty. That is.

Note also that some projects can be structured so that they provide the option to reduce capacity or temporarily suspend operations. Growth Options A growth option allows a company to increase its capacity if market conditions are better than expected. When evaluating a potential project. The real options approach shows that increased uncertainty can lead to a higher asset value if managers identify and use their options to flexibly respond to unfolding events. Flexibility Options Many projects offer flexibility options that permit the firm to alter operations depending on how conditions change during the life of the project. if you delay. For example. The option to delay is valuable only if it more than offsets any harm that might come from delaying.In the traditional view a higher level of uncertainty leads to a lower asset value. others can be abandoned. There are several types of growth options. Such investment timing options can dramatically affect a project’s estimated profitability and risk. however. when more information is available. In practice. The option to delay is valuable when market demand is uncertain. Investment Timing Options Conventional NPV analysis implicitly assumes that projects will either be accepted or rejected. even though market conditions might deteriorate and cause lower than expected cash flows. Several types of real options are often present. or other barriers to entry. licenses. but it is also valuable during periods of volatile interest rates. The option to delay is usually most valuable to firms with proprietary technology. A third type of growth option is the opportunity to add new products. and managers should always look out for them. patents. because these factors lessen the threat of competition. Typically. companies sometimes have a third choice – delay the decision until later. One lets a company increase the capacity of an existing product line. The second type of growth option allows a company to expand into new geographic markets. including complementary products and successive “generations” of the original product. While some projects must be operated over their full economic life. either inputs or outputs (or both) can be changed. Abandonment Options Many projects contain an abandonment option. some other company might establish a loyal customer base that makes it difficult for your company to later enter the market. since the ability to wait can allow firms to delay raising capital for projects until interest rates are lower. Even more important. The first step in valuing projects that have embedded options is to identify the options. managers should try to create options within projects. Quantitative Methods in Capital Budgeting and Real Options Techniques 36 . which implies that they will be undertaken now or never. standard DCF analysis assumes that the assets will be used over a specified economic life.

where future iterations are updated with the latest data and assumptions. Therefore. Given that certain projects are related to others. the analyst can then choose from a list of options to analyze in more detail.5. but must be identified through analysis and judgment. several iterations of the real options analysis should be performed. The analysis will provide the optimal allocation of investments across multiple projects. for long-horizon projects. choose. risk tolerances. Quantitative Methods in Capital Budgeting and Real Options Techniques 37 . portfolio optimization is crucial. Based on the overall problem identification occurring during the initial qualitative management screening process. which is the future cash flow series. In addition. Portfolio and Resource Optimisation Portfolio optimization is an optional step in the real options framework. ahead of such uncertainty and risks. the volatility is measured as the standard deviation of the logarithmic returns on the free cash flows stream. and so forth. there are opportunities for hedging and diversifying risks through a portfolio. switch. Update Analysis Real options analysis assumes that the future is uncertain and that management has the right to make midcourse corrections when these uncertainties become resolved or risks become known. Based on the identification of strategic optionalities that exist for each project or at each stage of the project. the option to expand. If the analysis is done on multiple projects. Real Options Modelling and Analysis Through the use of Monte Carlo simulation. when these risks become known.1 Real Options Valuation Approach The real options valuation approach can be summarised in the following steps: Real Options Problem Framing Real options are not specified in a contract. certain strategic optionalities would have become apparent for each particular project. Developing a good application frame is the most important step in the real options approach. we assume that the underlying variable is the future profitability of the project. the analysis should be revisited to incorporate the decisions made or revising any input assumptions. the present value of future cash flows for the base case discounted cash flow model is used as the initial underlying asset value in real options modelling. In real options. The strategic optionalities may include. portfolio optimization takes into account all these to create an optimal portfolio mix. have time and resource constraints. the analysis is usually done ahead of time and thus. Because firms have limited budgets. As firms do not only have single projects. Sometimes. and so forth. abandon. Usually. contract. management should view the results as a portfolio of rolled-up projects. This is because the projects are in most cases correlated with one another and viewing them individually will not present the true picture. An implied volatility of the future free cash flow or underlying variable can be calculated through the results of a Monte Carlo simulation previously performed. while at the same time have requirements for certain overall levels of returns. among other things. the resulting stochastic discounted cash flow model will have a distribution of values.

Figure 5. The standard deviation is $1.838.2 Timing Option .820 and that of the average branch $402. which gives the payoffs of the high-demand scenario. if demand is average or high. Quantitative Methods in Capital Budgeting and Real Options Techniques 38 . with first year sales of 38.600 units. The project could be implemented immediately.438 the average-demand branch in the middle has an NPV of $451. laid out as a time line. with first year sales of 26.240. Let us assume that there is a 25% chance that demand for the new device will be very high. The expected NPV if the decision is delayed for one year is $725. when more information about demand would be available. Figure 5. Each possible outcome is shown as a “branch” on the tree.711.2 is set up similarly except that it shows what happens if the decision is delayed and the project is implemented only if demand turns out to be high or average. and a 25% chance that demand will be low.096. Since there is a 25% probability of weak demand with losses of -$427. The sum in the last column shows that the expected NPV is $384. while the NPV of the low-demand branch is -$1.73 which confirms the project’s riskiness.5. the NPV in this case will also be zero. the project is clearly risky.2.565. as shown in the bottom branch.000 units. Each branch shows the cash flows and probability of a scenario. There is a 50% chance of average demand. Thus.893.1 Decision Tree Analysis of Timing Option: Proceed with project today The expected NPV is the weighted average of the three possible outcomes.652. no money will be spent at Year 1 and no cash flows will be received in the following years. In this case the investment will be made only if demand is sufficient to provide a positive NPV.963. the future cash flows depend on the demand for wireless internet browsing devices. The NPV of the high-demand branch is $2. has an NPV of $2. or it could be chosen to delay the decision until next year. Then.2.000 units.Decision Tree Method Assuming the WebPulse project.891.1 presents a decision tree diagram of the scenario to proceed with the project today. the project will be implemented with the resultant cash flows as shown.2. which is uncertain. No cost is incurred now at Year 0 – here the only action is to wait. If demand is low. with the weight for each outcome being its probability. Figure 5.436. the top line. with first year sales of 48.348. while the coefficient of variation is 3. Because all cash flows under the low-demand scenario are zero.

the analyst must find a standard financial option that resembles the project’s real option. Additionally. To do this.Figure 5. Note that the timing option mentioned for the WebPulse case resembles a call option on a stock. but only if the stock’s price is higher than the exercise price will the owner exercise the option and buy the stock. 5. the standard deviation is much lower and the coefficient of variation is only 1.3 Timing Option . A call option gives its owner the right to purchase a stock at a fixed exercise price. The value of a call option can be determined by using the Black-Scholes Option Pricing Model: V = P ⋅ N (d1 ) − X ⋅ e − rRF t ⋅ N (d 2 ) d1 = ln( σ2 P ) + [rRF + ( ) ⋅ t ] 2 X σ t d 2 = d1 − σ t where: V = Current value of call option P = Current value of the underlying asset X = Cost of Investment rRF = Risk-free rate of return Quantitative Methods in Capital Budgeting and Real Options Techniques 39 .11 indicating that this scenario is also much less riskier.2.2 Decision Tree Analysis of Timing Option: Implement next year only if optimal This analysis shows that the project’s expected NPV will be much higher if the project is implemented the next year instead of proceeding immediately.Black Scholes Model It is often useful to obtain additional insights into the real option’s value by using an options pricing model.

as a proxy for the stock price we can use the present value of the project’s future cash flows. (1) The risk free rate is assumed to be 5%. that is the value of the project. or cost. the current price is the present value of all expected future cash flow. since the price of a stock is not affected by the exercise price of a call option.2. Therefore. (4) We need a proxy for the value of the underlying asset.1 shows the expected cash flows if the project is delayed.272. when we find its present value. Note that a stock’s current price is the present value of its expected future cash flows. (4) the current price of the stock.1 Estimation of value of underlying asset Quantitative Methods in Capital Budgeting and Real Options Techniques 40 . (2) the time until the option expires.000 to implement the project. (5) the variance of the stock’s rate of return.1 shows how one can estimate the present value of the project’s cash inflows. Just as the price of a stock includes all of its future cash flows.t = time to expiration σ = Volatility of the underlying asset N(d1) and N(d2) are the value of the normal distribution at d1 and d2 This equation requires five inputs: (1) the risk-free rate. (3) It will cost $10. and its current “price” is the present value of all its future expected cash flows. (5) The variance of the project’s expected return can be used to represent the variance of the stock’s return in the Black-Scholes model.000. The current value of the underlying asset is needed to be found. For our real option. including those that are expected even if we do not exercise the call option. the underlying asset is the project itself. (2) The decision upon whether or not to implement the project should be made in a year. so there is one year until the option expires. Note also that the exercise price for a call option has no effect on the stock’s current price. For a stock. Therefore. we ignore the project’s “exercise price”. Figure 5. the underlying asset is the delayed project.177. values need to be estimated for those five inputs. For the WebPulse case. which in Black-Scholes is the current price of the stock. Moreover.2. and its current “price” is the present value of its expected future cash flow. Figure 5. and this is the input we should use for the current price in the Black-Scholes model. Figure 5.2. (3) the exercise price. The present value of these cash flows as of now (Year 0) is $9. the present value of the project should include all its possible future cash flows. so the same amount is used for the exercise price X.

As calculated in Appendix A2.57%.0189 = 2% 1 Applying the above estimated values to the Black-Scholes formula yields a result of $404.394 as shown in Figure 5. where there are an infinite number of possible outcomes. σ2. It is reasonable to assume that the value of the project at the time when we must decide on undertaking it behaves similarly to the price of a stock at the time a call option expires.14 2 + 1) = 0. a wide range of outcomes is possible. For the WebPulse project. Thus. we can use the expected value and standard deviation of the project’s value to calculate the variance of its rate of return.2.2. we conclude that the final decision to proceed or not with the project should be made in one year when more information will be available. with the following formula: σ2 = ln(CV 2 + 1) t Here CV is the coefficient of variation of the underlying asset’s price at the time the option expires and t is the time until the option expires.2.The last required input is the variance of the project’s return.838 NPV under immediate implementation. Since this value is higher than the $384. as the volatility of the logarithmic returns of the future cash flows. Similarly.2 Application of Black-Scholes Model Quantitative Methods in Capital Budgeting and Real Options Techniques 41 . Another approach for estimating the variance takes into account the fact that demand is not really limited to the three scenarios – rather. we can still use the scenario data to estimate the variance of the project’s rate of return if it has an infinite number of possible outcomes. This is not the case for the WebPulse project thus the result cannot be fully trusted. it is found to be 59. while the three scenarios are simplifications of the true condition. Under this assumption. This method is usually calculated on a large amount of available data values. the stock price at the time a call option expires could take on one of many values. Figure 5. this method produces the following estimate of the variance of the project’s return: σ2 = ln(0.

The binomial representation of uncertainty is very flexible. A. the distribution of possible asset values can be flipped over to its more familiar horizontal form. As Figure 5.2 shows that as the interval of time between changes in value grows shorter. They are exact. In the most widely used version. They are also very specific in nature. and as Figure 5.1 The Binomial Representation of Uncertainty (a) In each short time interval the value of the asset A increases by u or decreases by d. as shown in Figure 5.3. The binomial option valuation model is based on a simple representation of the evolution of the value of the underlying asset. Quantitative Methods in Capital Budgeting and Real Options Techniques 42 .3. are easy to implement and easy to explain.3.3. Future asset values are calculated in the binomial tree.2(c). the asset has an initial value. only three outcomes are possible at the end of two years. (b) At the final date. the multiplicative binomial model of uncertainty. the final distribution of outcomes becomes smoother. as in Figure 5. in contrast.3. In each time period the underlying asset can take only one of two possible values. A very smooth representation of the final distribution is possible with weekly periods. the height of the bar is the frequency of obtaining that outcome over all possible paths in the binomial tree. quick. When the underlying asset changes value once per year. Figure 5. Figure 5.2(b). as in Figure 5. where there exist equations that can be solved given a set of input assumptions.3. and within a short time period either moves up to Au or down to Ad.1(b) shows. Figure 5. the up or down movements lay out the possible paths. Each bar on the distribution is placed at a single outcome.3.1(a) shows the binomial tree and how it results in a distribution of outcomes on the final date.2(a). Binomial lattices.1 shows.3 Binomial Lattice – Growth & Abandonment Option Closed-form solutions are models like the Black-Scholes.3.5. and easy to implement with the assistance of some basic programming knowledge but are difficult to explain because they tend to apply highly technical stochastic calculus mathematics. with limited modelling flexibility.

the expected return to the underlying asset is the risk-free rate of interest. rf.2 Shortening the Time Interval This figure shows that the distribution of outcomes becomes smoother as the number of price changes per year increases. but its volatility. Thus. For example. A very smooth representation of the distribution of asset values in two years is obtained with weekly price changes. using these risk-adjusted probabilities on the cash Quantitative Methods in Capital Budgeting and Real Options Techniques 43 . one can instead easily risk-adjust the probabilities of specific cash flows occurring at specific times. With continuous compounding. p. σ. the expected return during each period is p ⋅ Au + (1 − p) ⋅ Ad = e rf A The probability. weights the outcomes to obtain the risk-free rate of return and is called the risk-neutral probability.Figure 5. The specific parameter values are chosen so that the resulting final distribution corresponds to the empirical reality.3. instead of using a risky set of cash flows and discounting them at a risk-adjusted discount rate as in the discounted cash flow models. In other words. will be the same as that observed in the real economy. when the risk-neutral approach is applied to the binomial model.

.3. the higher the up and down factors. the binomial lattice approach requires two additional sets of calculations. each time-step has a stepping time of 0. present value of implementation cost of the option (X). u = 1/d) is given by: u = eσ d= p= δt 1 = e −σ u δt (e ( rf −b )⋅(δt ) − d ) (u − d ) The basic inputs are the present value of the underlying asset (S). Having determined these values. This reciprocal magnitude ensures that the lattices are recombining because the up and down steps have the same magnitude but different signs. The volatility measure is an annualized value. riskfree rate or the rate of return on a riskless asset (rf). the up and down factors (u and d) as well as a riskneutral probability measure (p). Quantitative Methods in Capital Budgeting and Real Options Techniques 44 .1 years. equating the variance of the return from the binomial model to that of the observed normal distribution gives: pu 2 + (1 − p )d 2 − [ pu + (1 − p )d ] 2 = σ 2 One solution to the above equations that assumes the underlying asset has symmetric up and down movements (i. This is the essence of binomial lattices as applied in valuing options. The down factor is simply the reciprocal of the up factor. multiplied by the stepping time less the down factor.3. Time-steps or stepping time is simply the time scale between steps. to create a binomial lattice. volatility of the natural logarithm of the underlying free cash flow returns in percent (σ). to the difference between the up and down factors. defined simply as the ratio of the exponential function of the difference between risk-free rate and dividend. and continuous dividend outflows in percent (b). multiply it with the up (u) and down (d) factors as shown below. Similarly. We see from the equations above that the up factor is simply the exponential function of the cash flow volatility multiplied by the square root of time-steps or stepping time (δt). In addition. There is no economic or financial meaning attached to these riskneutralized probabilities apart from the fact that it is an intermediate step in a series of calculations. at places along the future path these binomial bifurcations must meet.e.flows allows the analyst to discount these cash flows (whose risks have now been accounted for) at the risk-free rate. That is. the higher the volatility measure. In addition. if an option has a one-year maturity and the binomial lattice that is constructed has 10 steps. time to expiration in years (T). The second required calculation is that of the risk-neutral probability. the binomial lattice of the underlying asset value can be calculated. This risk-neutral probability value is a mathematical intermediate and by itself has no particular meaning. One major error real options users commit is to extrapolate these probabilities as some kind of subjective or objective probabilities that a certain event will occur – which is erroneous. The results obtained are identical. Note that there is one bifurcation at each node. multiplying it by the square root of time-steps breaks it down into the time-step’s equivalent volatility. Starting with the present value of the underlying asset at time zero (S0). creating an up and a down branch. as shown in Figure 5.

554. The higher the volatility measure. that the lattice is not a straight horizontal line but comprises up and down movements. and a discounted cash flow model will be adequate because the value of the option or flexibility is also zero. This evolution of the underlying asset shows that if the volatility is zero. starting with the underlying value of $451.329 and $208. Applying the binomial lattice equations. if volatility (σ) is zero.240.The intermediate branches are all recombining. the u is calculated as 2. In other words. then the up ( u = e σ δt ) and down ( d = e −σ δt ) jump sizes are equal to one. Figure 5. while the second lattice is the option valuation lattice. What is the total value of the project taking into account this growth option? Three steps need to be followed for the Binomial Lattice approach.16. The first lattice is always the lattice of the underlying asset. so the stepping-time turns out to be 1.3. Upward movements in the tree are along the row and downward movements are along the diagonal. Back to WebPulse project case. Establishing the Decision Rule and Folding Back the future values to the present. we multiply this value with the up and down factors to obtain $976. the higher the up and down factors as previously defined. while d as 0.3.46. The present value of the underlying asset is $451. Rolling Forward Figure 5.2.18% as calculated in Appendix A. The time to expiration is 5 years and the lattice is calculated in 5 steps. the volatility σ of the natural logarithm of the projects cash flows is 77.000 at any time over the next five years. Quantitative Methods in Capital Budgeting and Real Options Techniques 45 . Rolling Forward the value of the underlying asset. respectively.3 Binomial Lattice of the Underlying Asset Value In any options model. in a deterministic world where there are no uncertainties. as captured by the volatility measure. The risk-free rate is assumed 5%.240 as calculated from the base case NPV analysis. there is a minimum requirement of at least two lattices. It is this up and down uncertainty that generates the value in an option.4 shows the rollout of the binomial tree for the value of the WebPulse project. the higher the potential value of an option as higher uncertainties exist and the potential upside for the option increases. the lattice would be a straight line. let us assume that choosing to implement the WebPulse project gives management the option to expand and double its operation by further investing another $500. Hence. It is because there are uncertainties and risks.

776.3. Thus the value of the project is the maximum between expansion or continuation since management will choose the strategy that maximises profitability. Since management has the option of growth not only on year 5. Each endpoint is not very likely. or 2 x $21. At the end of 5 years there is an option to either expand. Hence. the decision rule of maximizing value is applied in parallel to folding back the values. the node F27 is calculated as the maximum between the decision rule establish earlier or the folded back value of nodes G27 and G28. For example.888 at the same node of the rolling forward lattice G13. but it is quite different from the current value of $451. For this node the folded back value at year 4 is: Quantitative Methods in Capital Budgeting and Real Options Techniques 46 . At node G23 the value of acquiring and expanding its operations is equivalent to doubling its existing capacity of $21. but can exercise this option at the end of any year until year 5. by spending $500.396. Folding Back the Values The final step in the binomial option valuation is to bring back future values to the present.516 to $21. the value of acquiring and expanding the firm’s operations is double this existing capacity less any acquisition costs.4 Valuation of Growth Option with Binomial Lattice Model The tree shows that in 5 years the value of WebPulse might range from $9.396.240.000 = $42. Establishing the Decision Rule The next step is to establish the decision rule.293.000 and doubling the operations or do nothing.Figure 5.888 $500.396.888.

Quantitative Methods in Capital Budgeting and Real Options Techniques 47 .3.5 Valuation of Growth Option with Binomial Lattice Model As can be seen from Figure 5.5 shows the relevant calculations. where management may choose to abandon the project at any time until the end of year 5 and collect the salvage values of the invested assets including the building and equipment.822 The remainder of the tree is filled in the same manner.589 which is greater than 2 x $20. Figure 5.589 .914 .516 (1-p)]e-rf = 20.678.240 without the growth option.000 = -$458. where the salvage values of the assets for each year (row 11) are taken from the results of Figure 2. while the option itself is worth $8. If a real options approach is not used. Having an option and sometimes keeping this option open are valuable given a highly uncertain business environment.227. thus: Growth Option Value = $746. the project will be undervalued because there is a strategic option to expand its current operations but not an obligation to do so and will most likely not do so unless market conditions deem it optimal.914 considerably higher than the initial $451.$451.549 p + 9.$500. The growth option itself can be valued as the difference between WebPulses value with and without the option. there exists the option of abandonment. Let us now assume that instead of the growth option. resulting in a current value of WebPulse of $746. Figure 5.673 The real options value is worth an additional 65 percent of existing business operations.5 the value of the project with the abandonment option results to $8.240 = $295.[44.636.

but uncertainty does increase over time. and ε is a simulated variable.4.4. For instance. Notice that risk may or may not increase over time. but it becomes more and more difficult the further one goes into the future. µ is a drift term or growth parameter that increases at a factor of time-steps δt. a probability distribution can be constructed at each time period. If we were to attempt to forecast future cash flows while attempting to quantify uncertainty using simulation.5.3. This is the nature of the cone of uncertainty. as shown in Figure 5. while σ is the volatility parameter. even when business risks remain unchanged.1. In essence.1 shows a “cone of uncertainty. growing at a rate of the square root of time. Figure 5. a well prescribed method is to simulate thousands of cash flow paths over time. we can clearly see the similarities in triangular shape between a cone of uncertainty and a binomial lattice as shown in Figure 5.3.” where we can depict uncertainty as increasing over time. Brownian Motion on the other hand is a continuous stochastic simulation process.4 Geometric Brownian Motion Simulation Model Figure 5.4. usually following a normal distribution with a mean of zero and a variance Quantitative Methods in Capital Budgeting and Real Options Techniques 48 .1 were generated using a Geometric Brownian Motion with a fixed volatility. A Geometric Brownian Motion can be depicted as: δS S = µ (δt ) + σε δt Where a percent change in the variable S (denoted δS S ) is a combination of a deterministic part (µ(δt)) and a stochastic part ( σε δt ). a binomial lattice is simply a discrete simulation of the cone of uncertainty. Based on all the simulated paths. The simulated pathways of Figure 5. which depicts uncertainty as increasing over time.4. Here. it is usually much easier to predict business conditions a few months in advance.1 The Cone of Uncertainty Based on the cone of uncertainty.

In this case the value of the growth option will be calculated. The difference between the stochastic process simulation and the binomial lattice approach in paragraph 5. This is seen in the cone of uncertainty. the Brownian motion equation is used. In the Geometric Brownian Motion simulation model. Note that the different types of Brownian Motions are widely regarded and accepted as standard assumptions necessary for pricing options.4.2 Growth Option Calculation with Geometric Brownian Motion Simulation Quantitative Methods in Capital Budgeting and Real Options Techniques 49 . where the width of the cone increases over time. the level of uncertainty increases over time at a factor of ( σ δt ). where management has the option of doubling the operations of the project by investing another $500. Notice that the volatility (σ) remains constant throughout several thousand simulations. the harder it is to predict the future. instead of predicting the future values of the underlying asset with a binomial lattice. the level of uncertainty grows at the square root of time and the more time passes.3 is that the stochastic simulation does not permit the performance of decision rules when folding back. Brownian Motions are also widely used in predicting stock prices. Only the simulated variable (ε) changes every time.000.2 shows a sample of the simulation for the WebPulse project. where the option to expand can only be exercised at the end of the expiration period and not until the end of the expiration period as in an American type call option. Figure 5. This is equivalent to a European type call option.of one. Although the risk or volatility measure (σ) in this example remains constant over time.4. That is. Figure 5.

suggests there is high value in the project taking into account the option of growth. Quantitative Methods in Capital Budgeting and Real Options Techniques 50 . Obviously. each simulation trial will produce an entirely different asset evolution pathway. This value is then discounted at the risk-free rate to obtain the call value at time zero. At the end of the 100th timestep. the value of the asset at the first time-step is equivalent to: S1 = S 0 + δS1 = S 0 + S 0 ⋅ (rf (δt ) + σε δt ) The value of the asset at the second time-step is hence: S 2 = S1 + δS 2 = S1 + S1 ⋅ (rf (δt ) + σε δt ) and so forth.The first step is to determine the number of steps to simulate. that is: C 0.4.i . Hence.4. In the WebPulse case 100 steps were chosen (Figure 5. This is the call value C100. Applying simulation runs for 1000 trials (only 49 are depicted in Figure 5. the higher the number of simulations and the higher the number of steps in the simulation.i ⋅ e − rf (T ) This is a single-value estimate for a single simulated pathway. Starting with the initial asset value of $451. That is.240 (S0). the function is Max[2 x S10.i at time 100 for the ith simulation trial.X. the maximization process is then applied. the more accurate the results. the change in value from this initial value to the first period is seen as δS1 = S 0 ⋅ ( rf (δt ) + σε δt ) . as in the binomial lattice valuation case. all the way until the terminal 100th time-step. 0].790.000 implementation cost. The result. for the growth option with a $500.2 depicts only the first 15).i = C100.2) and obtaining the mean value of C0 yeilds $519. Notice that because ε changes on each simulation trial.

Future free cash flow streams It may be difficult to estimate future cash flows as are all highly predictable and they are usually stochastic and risky in nature. Because of project complexity and so-called externalities.. decision options. unplanned outcomes (e. Once launched.6. Project discount rate used is the There are multiple sources of business risks with opportunity cost of capital. interdependencies. Sometimes projects cannot be evaluated as stand-alone cash flows. Not cash flow streams are fixed for all decisions are made today.across projects or time. firms are portfolios of projects and their resulting cash flows. rate. all projects are Projects are usually actively managed through passively managed.g. as some may be the future. and synergy. Projects are “mini firms. and Uncertainty and variability in future outcomes. intangible. deterministic. and so forth. Distributed. when uncertainty becomes resolved. including checkpoints. All risks are completely Firm and project risk can change during the accounted for by the discount course of a project. The following specific advantages for risk analysis can be highlighted: 1. diversifiable risk. or Many of the important benefits are intangible are assets or qualitative strategic positions. it may be difficult or impossible to quantify all factors in terms of incremental cash flows. Unknown. and some are diversifiable which is proportional to non. budget constraints. immeasurable factors valued at zero. Monte Carlo analysis is a useful tool extending the depth of project appraisal and enhancing the investment decision. strategic vision and entrepreneurial activity) can be significant and strategically important. All factors that could affect the outcome of the project and value to the investors are reflected in the DCF model through the NPV or IRR. deferred to the future. whole firms.” and With the inclusion of network effects. A project whose single-value NPV is small may still be accepted following risk analysis on the grounds that its overall chances for yielding a satisfactory return are greater than is the probability of Quantitative Methods in Capital Budgeting and Real Options Techniques 51 . Conclusions Having examined a wide range of capital budgeting valuation techniques the following observations can be made. It enhances decision making on marginal projects. project life cycle. they are interchangeable with diversification. different characteristics. Traditional valuation methods have several drawbacks with regards to their assumptions and are summarized in the following table: Assumptions Realities Decisions are made now.

9. the probabilistic approach is a methodology which facilitates empirical testing. It facilitates the thorough use of experts who usually prefer to express their expertise in terms of a probability distribution rather than having to compress and confine their opinion in a single value. 4. Very often a new project concept is formulated that needs to be developed into a business opportunity. a marginally positive project could be rejected on the basis of being excessively risky. Before any real expenses are incurred to gather information for a full feasibility study it is possible to apply risk analysis widening the margins of uncertainty for the key project variables to reflect the lack of data. 10. The execution of risk analysis in a project appraisal involves the collection of information which to a large part reflects the acquired knowledge and expertise of top executives in an organisation. It bridges the communication gap between the analyst and the decision maker. project risk may be contractually Quantitative Methods in Capital Budgeting and Real Options Techniques 52 . It helps reduce project evaluation bias through eliminating the need to resort to conservative estimates as a means of reflecting the analyst's risk expectations and predispositions. It screens new project ideas and aids the identification of investment opportunities. By getting the people who have the responsibility of accepting or rejecting a project to agree on the ranges and probability distributions used in risk analysis the analyst finds an invaluable communication channel through which the major issues are identified and resolved. 6. Once the various sources of risk have been assessed. Unlike the prediction of deterministic appraisal which is almost always refuted by the actual project result. The decision maker in turn welcomes his involvement in the risk analysis process as he recognises it to be an important management decision role which also improves his/her overall understanding of the appraisal method. If the cost for obtaining such information is greater than the expected benefit likely to result from the purchase of the information then the expense is not justified. It aids the reformulation of projects to suit the attitudes and requirements of the investor. The need to define and support explicit assumptions in the application of risk analysis therefore forces the analyst to also critically review and revise the base-case scenario. It highlights project areas that need further investigation and guides the collection of information. It supplies a framework for evaluating project result estimates. A substantial investment of human and financial resources is not incurred until the potential investors are satisfied that the preliminary risk/return profile of the project seems to be acceptable. Likewise. or one with a lower NPV may be preferred to another with a higher NPV because of a better risk/return profile. 5. Risk analysis can contain the costs of investigation and fieldwork aiming at improving the accuracy of a forecast relating to particular project variables. 3. 7. The difficulty in specifying range limits and probability distributions for risk analysis often resides in the fact that the projected values are not adequately researched. 2. 8. It provides the necessary information base to facilitate a more efficient allocation and management of risk among various parties involved in a project.making an unacceptable loss. A project may be redesigned to take account for the particular risk predispositions of the investor. It induces the careful re-examination of the single-value estimates in the deterministic appraisal.

Binomial lattices. Closed-form solutions like the Black-Scholes model. This creates a win-win situation where risks are mitigated and returns are enhanced. Moreover. They are also very specific in nature.allocated to those parties who are best able to bear it and/or manage it. the Real Options approach displays a “tigher” distribution with higher returns as shown below. So from a “wide” distribution with low returns as a result of DCF analysis. In retrospect. are easy to implement and easy to explain. quick. since we can define risk as uncertain fluctuations in revenues and the NPV level. which includes this opportunity to make midcourse corrections when new information becomes available. and valuing the project in terms of its “real” or intrinsic value. where equations exist that can be solved given a set of input assumptions are exact. Quantitative Methods in Capital Budgeting and Real Options Techniques 53 . They are also highly flexible but require significant computing power and time-steps to obtain good approximations. Comparing the approach used in a traditional Discounted Cash Flow (DCF) method to Real Options. the upside risks are maximized such that the returns are increased because a project will only be executed when the best-case scenario occurs. all downside risks are mitigated in Real Options because you do not execute a project if the nominal or worst-case scenario occurs in time. simply by having the right strategic optionalities available. it enables the testing of possible contractual arrangements for the sale of the products or the purchase of project inputs between various parties until a satisfactory formulation of the project is achieved. in contrast. acting appropriately. with limited modelling flexibility. and easy to implement with the assistance of some basic programming knowledge but are difficult to explain because they tend to apply highly technical stochastic calculus mathematics.

A case study for Egnatia Odos S.T. 2007 Quantitative Methods in Capital Budgeting and Real Options Techniques 54 . & Angelou G. Galimaridou A.A. “Information Systems Research”...References Amram M. Boston. p.. Beech Tree Publishing. 1994. no.. C. “WebPulse & MyWeb Business Plan”.. Athens Information Technology. “A case for using real options pricing analysis to evaluate information technology project investments”. 10.... “Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions”. 1999. F. “Financial Management: Theory and Practice”. ”Real Options – Managing Strategic Investment in an Uncertain World”. vol.. 55. Ehrhardt M.. Houlis P. Theodoropoulos D. “Risk Analysis in Investment Appraisal”. Savvides.. Cambridge University Press. “Capital Budgeting : Financial Appraisal of Investment Projects”. Thomson – South West Mun J. “Communications & Strategies”. 70-86. & Kauffmann R.. Brigham E. McGraw Hill International Dayananda D. Pitsikalis C. Harrison S.A. 2002 Savvakis C.”. & Trigeorgis L. Oxford University Press.. Irons R. 2004 Benaroch M.J. G. “Investment Science”. Hawkins. Schilling M. & Kulatilaka N. John Wiley & Sons Luenberger D.. Merchant. Jerbohn J. Economidis A. & Rowland P. “Broadband Investments Analysis Using Real Options Methodology. 1999 Smit H. No.p. Massachusetts.. McGraw Hill International Anthony... 1998 Iatropoulos A.. Harvard Business School Press. “Strategic Management of Technological Innovation”. 1. “Quantifying the Strategic Option Value of Technology Investments”. “Accounting – Text & Cases”.

you could invest it. The process of going from today’s values. the future value of an initial lump sum at the end of n years can be found by applying the formulae: FVn = PV ⋅ (1 + i ) n Where i equals the interest rate per year. In general. Thus. to future values (FVs) is called compounding. or present values (PVs). if you had it now.Appendix A. The process of finding present values from future values is called discounting and is the reverse of compounding.1 Time Value of Money A dollar in hand today is worth more than a dollar to be received in the future because. PV = FVn ⋅ ( 1 n ) 1+ i Quantitative Methods in Capital Budgeting and Real Options Techniques 55 . earn interest and end up with more than one dollar in the future.

and x is the average X value. as illustrated below in Table A. we have six cash flows but only five cash flow returns. convert them into relative returns. and Monte Carlo simulation is not required in order to obtain a singlepoint volatility estimate. However. That is. The results of such an analysis will then yield a forecast distribution Quantitative Methods in Capital Budgeting and Real Options Techniques 56 . Table A. Performing a Monte Carlo simulation at the discounted cash flow level is highly appropriate because a distribution of volatilities can be obtained and used as input into a real options analysis. Then take the natural logarithms of these relative returns. In addition. auto-correlated cash flows (estimated using timeseries forecasting techniques) or cash flows following a static growth rate will yield volatility estimates that are erroneous. The standard deviation of these natural logarithm returns is the volatility of the cash flow series used in a real options analysis. for real options analysis. for time periods 0 to 5. Notice that the number of returns is one less than the total number of periods. thereby running thousands of trials and reducing the risk of obtaining a single erroneous volatility estimate. Starting with a series of forecast future cash flows. the relative returns will be a negative value.1. the volatility measure does not fully capture the possible cash flow downside and may produce erroneous results. including when cash flows are negative over certain time periods.2.2. That is. This approach is mathematically valid and is widely used in estimating volatility of financial assets. Clearly there are advantages and shortcomings to this simple approach. there are several caveats that deserve closer attention. Care should be taken in such instances. Hence.2 Estimation of Volatility – Logarithmic Cash Flow Returns Approach The logarithmic cash flow returns approach calculates the volatility using the individual future cash flow estimates and their corresponding logarithmic returns.1 Future Cash Flow Estimates and their Corresponding Logarithmic Returns The volatility estimate is then calculated as: volatility = 1 n ∑ ( xi − x ) 2 = 25. Monte Carlo simulation can also be used in creating the discounted cash flow model that is used to calculate the cash flows.58% n − 1 i =1 where n is the number of Xs.A. and the natural logarithm of a negative value does not exist. This method is very easy to implement.

of real options values.2. with its relevant probabilities of occurrence. Figure A. Applying the above mentioned methodology to the WebPulse case yields the results presented in Figure A. rather than a single-point estimate.2. Volatility Estimation for WebPulse Project Quantitative Methods in Capital Budgeting and Real Options Techniques 57 .2.2.

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