Capital Investment Appraisal

In applied capital budgeting, however, the fundamental concept of managerial flexibility, or active project management, has been well accepted and long practiced. In the past, one way decision-makers have attempted to supplement a traditional analysis is with "what if" analyses, such as sensitivity analyses, scenario analyses, and simulation. However, richer and more efficient capital budgeting decision-making frameworks are needed. and they should directly translate into increased corporate effectiveness, profitability, and long-term survival in today’s globally competitive marketplace. (Black 637-354)
The primary enhanced decision-making framework is a "real option" analysis. During the last fifteen years, increasing attention has been given to the "real option" approach to capital investment decision-making. "Real options … allow managers to add value to their firm, by acting to amplify good fortune or to mitigate loss". When real options are present, the traditional DCF methodology may fail to provide an adequate decision-making framework because it does not properly value management’s ability to wait, to revise the initial operating strategy if future events turn out to be different from originally predicted, or to account for future (dis)investment. (Trigeorgis 202-224. Fabozzi 7-9. Grinblatt 9-15) Thus, calculating the value of the decision rights of managers to actively manage investment opportunities is not simply a matter of discounting. In addition, since management is not committed to revising the firm’s investment strategy or undertaking these future discretionary opportunities, the right to do so is truly an option. That is, managers undertake these opportunities only if and when they chose to do so. In practice, capital investments are determined by managerial discretion where the available options to invest in real assets is evaluated on an on-going basis and either exercised, deferred, or allowed to expire. An option-based approach is, therefore, an excellent representation of the managerial decision-making process.
To be simple the internal capabilities of a firm must be matched to its external opportunities in order for managers to maximize shareholders’ wealth. The real options are characterized by the flexibility they offer in timing of decisions involving the capabilities and opportunities of the firm (Walters and Giles 1-7. Ross 96-102. Chung 1215-1221. Copeland 15-22). The true NPV of a project can be viewed as the sum of the traditional NPV and the values of inherent real options:
True NPV = Traditional NPV + NPV of Real Options.
To clarify the value of options from active management, suppose that a firm considers producing a new product, which requires an initial outlay of $1 million. The capacity of the production facility over one period would be 40,000 units. The variable cost of producing one unit of this product is $390. The price of the product in one period from now would be either $300 or $500 with an estimated probability of 50 percent for each state of the nature. The appropriate discount rate for the project is 15 percent. The expected cash flow from the project after one period woul