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Q.3 What role is played by judgment and qualitative factors in the investment
selection? Is it justifiable?
A.3 In addition to the use of the sophisticated techniques for evaluation of capital
expenditure decision, the qualitative factors like urgency, strategy and
environment play significant role.
Vision or judgment of the future, e.g., market potential, possibility of technology
change, trend of government policies, opportunities and constraints of a particular
project, etc. is very critical for the success of the firm adopting the investment
projects. A growing firm maybe able to identify profitable opportunities without
making NPV or IRR computation.
Q.4 Is there any interface between strategy and the capital budgeting system? Why
should capital budgeting be seen within a strategic perspective?
A.4 Most companies consider strategy as an important factor in capital budgeting
decision evaluation. Management should spend its time in improving the quality
of decision in the context of overall strategy, e.g., overall objective achievements
of firm. This approach provides the decision-maker with a central theme as a
guideline for effectively allocating corporate financial resources.
Strategic management has emerged as a systematic approach in properly
positioning of firm in the complex environment by balancing multiple objectives,
for example, growth, competition, balance of products, total risk diversification,
and managerial capacity, etc. These reinforce the need for a strategic framework
for problem-solving under complexities and the relevance of strategic
considerations in investment planning. Capital budgeting decision involves large
investment such as acquisition of a new business or expansion in a new line of
business. Such decisions are generally handled by top management, and have
strategic importance.
Q.6 What are real options? Give examples of real options. How should real option be
evaluated?
A.6 Real options are those strategic elements in investments that help creating
flexibility of operations, or that have the potential of generating profitable
opportunities in the future for the firm. Real options provide discretion to
managers to take certain investment decisions, without any obligation, for a given
price. Real options are not confined to real assets only. Patent, R&D, brands etc.
are examples of assets that have a value to the owner.
The option pricing theory provides a framework for valuing strategic investments.
The methods of valuing real options are the same as the financial options.
An investment with real option consists of two values: the value of cash flows
from the project’s assets plus the value of any future opportunity (option) arising
from holding the asset.