Value a Hypothetical Situation
For managers, deciding what to invest in can sometimes
seem daunting. Financial professionals are regularly called
on to put a value on hypothetical situations: investing
in a new factory, for example, or expanding abroad. Often
they use the concept of “net present value”
to determine whether the profits generated by a project
would be worthwhile. This, claims Tom Copeland, a former
finance professor and author of a textbook on financial
theory, and Vladimir Antikarov, who works with Mr Copeland
at Monitor Corporate Finance, is where companies cheat
themselves. A better approach would be to analyse potential
projects as options to be exercised.
Net present value does not take into account the flexibility
inherent in certain projects. Say, for example, your oil
company is deciding whether or not to invest in an offshore
drilling project. Net present value calls for you to measure
the project's eventual revenue—if it's
successful—against the cost of investment using
cash inflows. But that may be too black and white an approach.
You can first invest money to explore the field and determine
the best location for drilling, then decide whether or
not to drill; you can also decide how much time and money
to invest in exploring. Each option—to explore or
not, explore quickly or slowly, drill or not—has
a value in itself which should (and can, thanks to new
computer programmes based on Monte Carlo analysis) be
factored into determining the overall value of the project.
(Monte Carlo analysis generates random values to determine
the potential outcomes of alternative scenarios). A real-options
analysis lets you gauge the project's value with
all the options taken into account. More often than not,
the result of real-options analysis is higher than that
of a net present value analysis: flexibility itself has
become an asset.
Whether or not managers know it, they rely increasingly
on options theory. Temporary workers, who can become permanent
later, are an example of real options in the field of
personnel. Companies considering investment abroad in
effect use the theory when they draw up contingency plans
for political instability. Entrepreneurs are more likely
to embrace real options: being more comfortable with risk,
they're also more likely to recognise the value of flexibility.
In real-options analysis, failure is just another option,
with no stigma attached. Thus real-options analysis is
not simply a matter of more accurate financial projections.
If it leads managers to see a value in flexibility, they
might become more confident in their ability to cope with
Source: The Economist