Understand the capital budgeting process: Document the policies and practices of companies in India and compare them with that of the companies in developed countries. Understand the linkage between corporate strategy and investment decisions. Define strategic real options. Show the valuation of real options.

1. Chapter - 13
Real Options, Investment
Analysis and Process

2. 2Financial Management, Ninth
Chapter Objectives
Understand the capital budgeting process:
 Document the policies and practices of
companies in India and compare them with
that of the companies in developed countries.
 Understand the linkage between corporate
strategy and investment decisions.
 Define strategic real options.
 Show the valuation of real options.

3. 3Financial Management, Ninth
We will answer the following questions
 What is the process of capital budgeting that
companies employ?
 What capital budgeting policies and practices do they
follow?
 Is there any link between the corporate strategy and
capital budgeting?
 What are the strategic aspects of capital budgeting?
 Can the discounted cash flow technique handle the
strategic aspects of capital investments?
 How can we evaluate investment projects that are
capable of creating future opportunities and flexibility
(options) for companies?

4. 4Financial Management, Ninth
Capital Investments
 Capital investments should include all those
expenditures, which are expected to produce benefits
to the firm over a long period of time, and encompass
both tangible and intangible assets. Thus R&D
expenditure is a capital investment. Similarly, the
expenditure incurred in acquiring a patent or brand is
also a capital investment.
 Few companies classify capital expenditures in a
manner, which could provide useful information for
decision-making. Their classification is (i) replacement,
(ii) modernisation, (iii) expansion, (iv) new project,
(v) research and development, (vi) diversification, and
(vii) cost reduction.

5. 5Financial Management, Ninth
Capital Investment Planning and
Control
 At least five phases of capital expenditure
planning and control can be identified:
 Identification (or origination) of investment
opportunities.
 Development of forecasts of benefits and costs.
 Evaluation of the net benefits.
 Authorisation for progressing and spending capital
expenditure.
 Control of capital projects.

6. 6Financial Management, Ninth
Investment Ideas: Who Generates
 Most proposals, in the nature of cost reduction or
replacement or process or product improvements
take place at plant level.
 The contribution of top management in generating
investment ideas is generally confined to expansion
or diversification projects.
 The proposals may originate systematically or
haphazardly in a firm.
 The most common methods used are:
 management sponsored studies for project identification,
 formal suggestion schemes,
 consulting advice.
 review of researches done in the country or abroad,
 conducting market surveys,
 deputing executives to international trade fairs for identifying new
products/technology.

7. 7Financial Management, Ninth
Developing Cash Flow Estimates
 Estimation of cash flows requires collection
and analysis of all qualitative and quantitative
data, both financial and non-financial in
nature. Large companies would generally
have a management information system
(MIS) providing such data.

8. 8Financial Management, Ninth
Project Evaluation
 The net present value method is theoretically
the most desirable criterion as it is a true
measure of profitability; it generally ranks
projects correctly and is consistent with the
wealth maximization criterion. In practice,
however, managers’ choice may be governed
by other practical considerations also.
 Some Important Factors
 Cut-off Rate
 Recognition of Risk
 Capital Rationing

9. 9Financial Management, Ninth
Authorisation
 Screening and selection procedures may
differ from one company to another. When
large sums of capital expenditures are
involved, the authority for the final approval
may rest with top management. The approval
authority may be delegated for certain types
of investment projects.
 Senior management tightly control capital
spending. Budgetary control is also
exercised rigidly. The expected capital
expenditure proposals invariably become a
part of the annual capital budget in all
companies.

10. 10Financial Management, Ninth
Control and Monitoring
 Advantages of reappraisal:
 (i) improvement in profitability by positioning the
project as per the original plan;
 (ii) ascertainment of errors in investment planning
which can be avoided in future;
 (iii) guidance for future evaluation of projects; and
 (iv) generation of cost consciousness among the
project team.
 A few companies abandon the project if it
becomes uneconomical.

11. 11Financial Management, Ninth
Qualitative Factors and Judgement in
Capital Budgeting
 In practice, however, companies, although tending to
shift to the formal methods of evaluation, give
considerable importance to qualitative factors.
 Most companies in India are guided, one time or
other, by three qualitative factors: urgency, strategy,
and environment.
 Some companies also consider intuition, security and
social considerations as important qualitative factors.
 Companies in USA consider qualitative factors like
employees’ morals and safety, investor and customer
image, or legal matters important in investment
analysis.

12. 12Financial Management, Ninth
Role of Judgement
 Vision of judgement of the future plays an important role.
 The opportunities and constraints of selecting a project, its
evaluation of qualitative and quantitative factors, and the
weightage on every bit of pros and cons, cost-benefit analysis,
etc., are essential elements of judgement.
 Judgement and intuition should definitely be used when a
decision of choice has to be made between two or more, closely
beneficial projects, or when it involves changing the long-term
strategy of the company. For routine matters, liquidity and
profits should be preferred over judgement.
 It (judgement) plays a very important role in determining the
reliability of figures with the help of qualitative methods as well
as other known financial matters affecting the projects.

13. 13Financial Management, Ninth
Investment Decisions and Corporate
Strategy
 Strategy provides the decision-maker with a central
theme or a big picture to keep in mind at all times as
a guideline for effectively allocating corporate
financial resources.
 As argued by a chief financial officer—Allocating
resources to investments without a sound concept of
divisional and corporate strategy is a lot like throwing
darts in a dark room.
 Strategic framework provides a higher-level
screening and an integrating perspective to the whole
system of capital expenditure planning and control.
Once strategic questions have been answered,
investment proposals may be subjected to the DCF
evaluation.

14. 14Financial Management, Ninth
Managerial Flexibility and Commitment
 STRATEGIC REAL OPTIONS –
 Real options are those strategic elements in
investments that help creating flexibility of operations,
or that have the potential of generating profitable
opportunities in the future for the firm.
 Real options provide discretion to managers to take
certain investment decisions, without any obligation, for
a given price.
 Real options are not confined to real assets only.
Patent, R&D, brands etc. are examples of assets that
have a value to the owner.
 The capital investments should be viewed as strategic
investments that incorporate real options. Hence the
value of a capital investment will also include the value
of the strategic elements in the investment.

15. 15Financial Management, Ninth
Valuing Real Option
 An investment with real option consists of two
values: the value of cash flows from the
project’s assets plus the value of any future
opportunity (option) arising from holding the
asset.
 We use the Binomial method and Black-
Scholes method of option pricing for valuing
real options.

16. 16Financial Management, Ninth
Types of Real Options
 Valuing Option to Expand
 Valuing a Patent
 Valuing The Option To Abandon
 Valuing Option to Delay
 Flexibility and Operating Options

17. 17Financial Management, Ninth
Capital Budgeting Decision-making
Levels
 For planning and control purposes, three levels of
decision-making have been identified:
 Operating,
 administrative, and
 strategic.
 Keeping in view the different decision-making levels,
capital expenditures could be classified in a way,
which would reflect the appropriate managerial
efforts to be placed in planning and controlling them.
 One useful classification could be:
 (i) strategic projects,
 (ii) expansion in the new line of business,
 (iii) general replacement projects,
 (iv) expansion in the existing line of business, and
 (v) statutory required and welfare projects.