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Options analysis for Capital Budgeting decisions

The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flows, and then you discount them to the present value to compare NPV of the various choices.  If the project has a positive NPV, you accept the project, if its negative you reject it.  

The problem with this analysis is that it doesn't properly value Options.   You  often have the choice to invest more at a later date.  You might have the option to invest just a little now...to get the project rolling, and then if its going well...then you invest a little bit more at a later date.  This is the essence of the Venture Capital Method of Valuation.   This is often referred to as a "decision tree" analysis which handles risk in a more sophisticated manner.   With this method, you value the firm today assuming that future decisions will be optimal (even before knowing what those decisions are going to be).

Starting a project is like purchasing a call option.  If further information is revealed that makes the investment seem attractive, then you have bought the right to that investment in the future.   In general, it is in investors best interest to not exercise the call option immediately, but rather to wait until the end of the time period to see what new information is presented.

The problem with standard NPV analysis is that it does not consider the very real world flexibility that most managers (and Venture Capitalists) face.   An NPV analysis might show that a project should not be undertaken, but thinking in terms of options, you might be willing to invest a little for the option of being there in the future.  This explains alot of seed funding of a few million dollars of Silicon Valley companies (that no-one but Venture Capitalist's can figure out why they are being funded).   Sometimes, its just a matter of believing in the vision of the entrepreneur, or the idea, or seeing potential for untapped market share, and a little VC money makes sense (if not in an NPV world).  By allowing the investing firm to change its investment policy later according to new information, a seemingly unwarranted investment can be justified. 

Managers that just use NPV are ignoring real-world flexibility in their analysis.   Please see more about capital budgeting process (project finance) here: capital budgeting

Options & Venture Capital analysis:

The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flows, and then you discount them to the present value to compare NPV of the various choices.  If the project has a positive NPV, you accept the project, if its negative you reject it.  

The problem with this analysis is that it doesn't properly value Options.   You  often have the choice to invest more at a later date.  You might have the option to invest just a little now...to get the project rolling, and then if its going well...then you invest a little bit more at a later date.  This is the essence of the Venture Capital Method of Valuation.   This is often referred to as a "decision tree" analysis which handles risk in a more sophisticated manner.   With this method, you value the firm today assuming that future decisions will be optimal (even before knowing what those decisions are going to be).

Starting a project is like purchasing a call option.  If further information is revealed that makes the investment seem attractive, then you have bought the right to that investment in the future.   In general, it is in investors best interest to not exercise the call option immediately, but rather to wait until the end of the time period to see what new information is presented.

The problem with standard NPV analysis is that it does not consider the very real world flexibility that most managers (and Venture Capitalists) face.   An NPV analysis might show that a project should not be undertaken, but thinking in terms of options, you might be willing to invest a little for the option of being there in the future.  This explains alot of seed funding of a few million dollars of Silicon Valley companies (that no-one but Venture Capitalist's can figure out why they are being funded).   Sometimes, its just a matter of believing in the vision of the entrepreneur, or the idea, or seeing potential for untapped market share, and a little VC money makes sense (if not in an NPV world).  By allowing the investing firm to change its investment policy later according to new information, a seemingly unwarranted investment can be justified. 

Managers that just use NPV are ignoring real-world flexibility in their analysis.

External Links:

• http://en.wikipedia.org/wiki/Real_options_analysis

Links to KookyPlan pages 

• capital budgeting
• financial modeling
• Options
• net present value
• product development
• invest

• Options
  Table of Contents: Options Foreign exchange Options gives you the right to purchase / sell a currency at a certain price (from now, up till an expiration date). You have the right to purchase (or se…
  Brian D Butler edited 7 mins ago
• Foreign exchange Options
  Options Gives you the right to purchase / sell a currency at a certain price (from now, up till an expiration date). You have the right to purchase (or sell), but you dont have to. On the other hand, the other…
  brian edited 9 mos ago
• call option
  exchange Options Gives you the right to purchase / sell a currency at a certain price (from now, up till an expiration date). You have the right to purchase (or sell), but you dont have to. On the other hand, the oth…
  brian edited 9 mos ago
• put option
  exchange Options Gives you the right to purchase / sell a currency at a certain price (from now, up till an expiration date). You have the right to purchase (or sell), but you dont have to. On the other hand, the oth…
  brian edited 9 mos ago
• currency hedging
  market) (c) options (see Options) (d) use the money market to hedge (e) sell your A/R to someone else ....companies that buy your receivables at a discount. Bankers Acceptance - is an ag…
  brian edited 3 mos ago
• business valuation
  available options, note that the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation. If the investor believes that the option pool of the co…
  Brian D Butler edited 1 wk ago
• Venture Capital Method of Valuation
  ons: Using "Options" to value a startup: The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flows,…
  Brian D Butler edited 2 mos ago
• Black-Scholes
  global-derivatives.com Options pricing using the Black-Scholes Model, Investment Analysts Society of Southern Africa The Black–Scholes Option Pricing Model, optiontutor Black, Merton, and Scholes: Their work and…
  brian edited 9 mos ago
• foreign currency trading
  exchange Options foreign exchange Swaps Definitions Dollar rate of return ADR - American Depository Receipt Discount - if a currency trades at a "discount" in the forward market Eurobonds Eurocurrency, E…
  Brian D Butler edited 1 mo ago
• Venture Capital
  it. Options & VC finance The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flows, and then y…
  Brian D Butler edited 1 wk ago
• Futures market
  1/2 as many options as "futures contracts" ) hold a margin account - shares are held to protect broker against loss individual can be a speculator by purchasing futures (like gambling in Vegas, except you are …
  brian edited 9 mos ago
• hedging
  Strategies using options: see more in our discussion about Options learn more here: http://www.amex.com/?href=/options/eductn/index_education.html Lo…
  Brian D Butler edited 2 mos ago
• net present value
  accounting for options: The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flows, and then you discount them to…
  Brian D Butler edited 1 hr ago
• seed funding
  ; Using "Options" to value a startup: The core of the NPV analysis assumes that you are sitting at time T=0, and that you have one decision to make.... You first calculate the expected cash flow…
  Unknown User edited 4 mos ago
• forward exchange rate
  market) (c) options (see Options) (d) use the money market to hedge (d) sell your A/R to someone else ....companies that buy your receivables at a discount. Bankers Acceptance - is an ag…
  brian edited 9 mos ago
• risk
  investments in options becomes more valuable as volatility rises. Why? because there is a greater chance that (due to the higher volatility), you might be "in the money". See our discussion on Options for mo…
  Brian D Butler edited 2 mos ago
• Valuations and internet companies
  consideration real options. for this reason, theories like Black-Scholes have attracted allot of attention. Some tools Here is a nice tool for estimating the value of your startup: Valuation Es…
  Brian D Butler edited 1 wk ago
• volatility
  investments in options becomes more valuable as volatility rises. Why? because there is a greater chance that (due to the higher volatility), you might be "in the money". See our discussion on Options for mo…
  Brian D Butler edited 2 mos ago
• derivatives
  Actually, options are the more complicated of all derivatives. Most of them are actually quite simple, and come in the form of futures (or forwards). Types of derivatives The diverse range of potential u…
  brian edited 8 mos ago
• financial statement analysis
  and stock options Criticism of EPS: does not consider amount of assets required. Two firms might have same EPS, but one uses 2x as many assets to generate those same earnings. Price-Earnings Ratio: P…
  brian edited 8 mos ago
• forward contracts
  exchange Options …
  brian edited 8 mos ago
•  

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