THE ROLE OF REAL OPTIONS IN CAPITAL BUDGETING THEORY & PRACTICE

1. BACK GROUND OF THE STUDY

Traditional discounted cash flow (DCF) analysis—where an asset’s cash flows are estimated and
then discounted to obtain the asset’s NPV—has been the cornerstone for valuing all types of
assets since the 1950s.
However, in recent years academics and practitioners have demonstrated that DCF valuation
techniques do not always tell the complete story about a project’s value, and that rote use of DCF
can, at times, lead to incorrect capital budgeting decisions.
DCF techniques were originally developed to value securities such as stocks and bonds.
Securities are passive investments—once they have been purchased, most investors have no
influence over the cash flows the assets produce. However, real assets are not passive
investments—managerial actions after an investment has been made can influence its results.
Furthermore, investing in a new project often brings with it the potential for increasing the firm’s
future investment opportunities. Such opportunities are, in effect, options—the right but not the
obligation to take some action in the future.
Real options are opportunities for management to change the timing, scale, or other aspects of an
investment in response to changes in market conditions. These opportunities are options in the
sense that management can, if it is in the company’s best interest, undertake some action;
management is not required to undertake the action. These opportunities are real, as opposed to
financial, because they involve decisions regarding real assets, such as plants, equipment, and
land, rather than financial assets like stocks or bonds.
So justification of the study (back ground of the study) is to show the relationship between DCF
and real option valuation, whether they both give the same result when used correctly or not,
assumptions required to perform real options valuations are unrealistic by pointing assumptions,
and empirical research on both corporate valuation practices and stock prices by considering real
options in to decision making.
2. STATEMENT OF THE PROBLEM
The statement of the problem is stated on page 35 as follows. Most academic knowledge about
capital budgeting practice is based on surveys and anecdotes. Surveys report that DCF is used
very widely in practice. For example, in a much cited survey by John Graham and Campbell
Harvey (2001), 75% of the 398 responding CFOs said they “always or almost always” use net
present value (NPV)—which relies on DCF—as a capital budgeting technique. But only 25% of

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 THE ROLE OF REAL OPTIONS IN CAPITAL BUDGETING THEORY & PRACTICE

those CFOs claimed to use real option methods. At the same time, many CFOs in the survey
reported always or almost always using many other methods, including IRR, payback, and P/E
multiples. A similar picture emerges from a survey by Patricia Ryan and Glenn Ryan (2002),
which reports that 85% of companies use NPV “always or often” while at most 15% use methods
such as real options, option pricing, and simulation.
If corporate managers do not strictly use traditional DCF methods to make investment decisions,
is there evidence that DCF either does or does not describe market prices? In a much cited 1995
article, Steve Kaplan and Rick Ruback examined highly-leveraged transactions (management
buyouts and leveraged recapitalizations) in which the transaction documentation contained
forecasts of cash flows. Using standard assumptions for DCF valuation, Kaplan and Ruback
found that the DCF estimates were relatively accurate, on average, but with a large standard
deviation. (The median log ratio of estimated value to transaction price was about 1.05; but 40-
50% of the estimates had errors greater than 15% and the standard deviation of the valuation
errors was around 25 %.) By focusing on the average error, one would conclude that DCF
accurately values the transaction prices. But one could reach the opposite conclusion by focusing
on the standard errors.
Research gap
In addition to the above, study did not properly explain the exact reason of companies for using
discounting cash flow over real options valuations.
Research questions
 Is the result different when using DCF and when using real options methods?
 Is it acceptable to use a constant discount rate in a multi-period DCF valuation?
 Can the company expand if profitable, contract if unprofitable, and so forth?
 Is the risk-neutral probability constant over time in a real options valuation?
3. OBJECTIVES OF THE STUDY
Objective of the study is to clarify the ideas in putting real options valuation to practice using
simple examples. We can observe that objective of the study is consistent with justification of
the study and statement of the problem.

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4. HYPOTHESIS OF THE STUDY

The study specified the following the following hypothesis in the form of assumptions to clarify
the application of the two methods, whether traditional DSF and real options valuations give the
same result, if properly applied.
Assumption1: The DSF and real options valuations provide the same answer
Assumption 2: Traditional DSF is an essential component of risk neutral valuation
Assumption 3: Risk neutral valuation is much simpler when projects become more
complex.
5. SIGNIFICANCE /IMPORTANCE OF THE STUDY
The researcher looked upon on increasing our understanding on how DSF and real option
valuations will bring the same answer when they are used correctly. And also showed that
surveys of corporate decision makers report that less than a quarter of companies say they use
real options when making capital budgeting decisions. Then the researcher set a base for future
studies on what factors bar applying real options valuation in valuing capital projects.
6. SCOPE OF THE STUDY
The research addressed different angles categorizing the issue under discussion by comparing the
DCF and real options valuations and, in so doing, showed that both methods provide the same
answers when used correctly. Address the complaint that the assumptions required to perform
real options valuations are unrealistic by pointing out that the assumptions typically used to
support DCF are at least as restrictive.
Argued that survey evidence that seems to show that corporate managers do not use real options
techniques in capital budgeting almost certainly underestimates the extent to which managers
take real options into account when making decisions, regardless of whether they use the formal
apparatus of option pricing theory.
The research also classified the projects in to two as projects that generate a single cash flow and
projects that generate multiple cash flows (multi period valuations).
Discussed empirical research on both corporate valuation practices and stock price that is
consistent with both managers and markets incorporating real options considerations into their
decision making. So the researcher’s coverage of issues is proper.

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7. LIMITATIONS OF THE STUDY

The research couldn’t regarded the qualitative aspects of the two valuations why firms
choose DSC over real options valuations, such as Size of the organization, type of operations,
complexity of calculations that may to some extent affect the result of the research.
8. METHODOLOGY OF THE STUDY
8.1 Research design
The research is an explanatory (descriptive) research type and considered different
projects in different ways to explain the relationship between discounting cash flows and
real options valuations. According to our opinion the research design is appropriate for
this type of researches.
8.2 DATA TYPE AND SOURCE
The researcher used qualitative and secondary data to conduct the research this can be
mentioned as follows
. The research design is longitudinal and multi method
. The research is non probability
. The researchers judgments are mixed with facts and emphasizes on the themes
. The researcher used academic literatures as a source for justification
8.3 Sampling design
The research population was found from secondary sources (survey by John Graham and
Campbell Harvey (2001)). 398 companies are taken as a sample to verify application of
discounting cash flows or real options valuations. Even though the qualitative
characteristics are not considered the sample taken is sufficient.
8.4 Data analysis techniques
The analysis of hypothesis was conducted by considering three assumptions,
Assumption 1, 2&3 are explained using related example, considering two projects,
project one a one period discounting problem and project two multi period discounting
cash flow valuations and compared DSC and real options valuations.
8.5 MODEL
Even though most of the analysis part requires comparison, the researcher a little bit used
econometric model as a summary.

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9. RESULTS- MAJOR FINDINGS AND DISCUSSION

The researcher discussed the results in two projects (single cash flow and multi-period cash flow)
considering the stated assumptions
The single cash flow assumption
The series of simple valuation examples demonstrates two important points: First, even if we
perform a real options valuation, a DCF valuation is necessary unless there is a forward price or
present value that we can observe in the market. Second, the DCF discount rate was different in
all three projects, whereas the risk-neutral probability remained the same. Using the same DCF
discount rate in all three projects produces materially incorrect values for Projects 2 and 3, while
using the same risk-neutral probability always produces the correct valuation. Although DCF
valuation is essential as a first step, risk-neutral valuation can greatly simplify the calculation in a
dynamic DCF problem where risk and beta change with different assumptions about how the
project is operated.
Multi period cash flow assumptions
The examples in this section have illustrated the well-established point that traditional static
DCF, using a constant discount rate, is a correct discounting method only under the special
assumption that risk resolves at a constant rate over time. A real options valuation, by contrast,
automatically addresses the problem of discounting cash flows even when risk premiums change
dynamically. A real options valuation also requires special assumptions; but in the examples we
have examined, stricter assumptions are required for a constant risk premium than are required
for constant risk-neutral probabilities. In any case, however, the concepts of a DCF valuation are
still required to characterize the risk of the project. So the researcher has properly discussed the
results of the research.
10. CONCLUSIONS AND RECOMMENDATIONS
The researcher argued that DCF and risk-neutral valuation both play an essential role in capital
budgeting calculations. Traditional DCF is a necessary input for a real option valuation, and real
option methods can greatly simplify otherwise daunting valuation problems. Even with valuation
problems that seem relatively straightforward, option valuation methods are helpful. But rather
than discuss valuation methods using the term “real options,” it may be more productive to
concentrate on the details of the economic and valuation issues that arise in specific contexts and
then decide the best way to obtain accurate prices.

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RECOMMENDATIONS
The study recommended that most managers do not claim to use real options methods when
making capital budgeting decisions, academic studies generally finds both managerial behavior
and market pricing to be consistent with the predictions of real option models. Managers can be
expected to find rules of thumb and ad hoc modifications of DCF and other traditional valuation
approaches that lead to better evaluation of the economics of a given project.
11. CRITICAL COMMENTS BY REVIEWERS
 When we see the overall aspect of the study, it tried to cover different directions to examine
the relationship between DSC and real options valuations. The questions stated in the
statement of the problem and the assumptions have matched to the objective of the study.
The data’s are collected from reliable sources.
 The conclusion and recommendations are given the way they address the research objective
and analysis & discussions. So this study can be a base for other researchers that conduct
their study on related areas.

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