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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 uncertainty.

Source: The Economist


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