cash flows, or which precludes the exploitation of significant benefits in the next period:
• if there occurs between now and the next period technical changes which must be embodied in new plant and equipment. These benefits would be lost if the investment occurred now, using an old vintage technology. The maturity period must be long to make this a likely event. On the other hand, learning by doing makes no dif- ference to the timing of an investment since it occurs as soon as the investment is made,
• if the total possible output is fixed – there is a limited reserve of some natural resource such as oil or timber involved or some well- located but limited supply of land, and if the price of the relevant output is likely to rise following an increase in demand, it might be beneficial to wait in order to take advantage of the increased price,
• if the period of exploitation of a competitive advantage is fixed by license or patent and delay reduces the period of advantage,
• if the level of risk declines over time and the value of a project rises with a lower rate of discount applied.
Measurement means a quantitative evaluation of the riskiness of the environment, the ideal being a risk measure which is unique and com- prehensive. To produce a single index requires a specification of all the relevant components and sub-components of the different risk types, a use of quantitative proxies for such components where direct measure- ment is not possible and a weighting of the individual components.
The measurement can be done within the enterprise or an external agency can implement it. Assessment is a major task and requires a considerable commitment of resources. It cannot be repeated fre- quently because of the cost involved. Moreover, the risk situation needs to be monitored between assessments. Monitoring means find- ing a signal(s) which indicates an increase or decrease in the relevant risk level and hopefully when a major revision of the assessment system is needed.
The previous chapter explored the kind of information which is needed in order to make an investment decision. Resources must be committed to gaining such information. A successful information strat- egy would identify all the relevant data needed to estimate the vari- ables in the expanded version of the net present value formula. An effective information strategy also analyses the implications of the inclusion of a project in the overall strategy. Acquiring the relevant information is critical to accurate risk assessment. There are issues which any information strategy must address:
• what maximum level of uncertainty to aim for,
• what resources to commit to removing uncertainty,
• selecting the relevant ‘readers’ of the external environment and institutionalising the process of reading that environment,
• how to identify relevant information from the general environment,
• what resources to get access to, and mechanisms to develop, for processing available information,
• how to link information gathering and processing to strategy making.
Decision makers rarely know probabilities concerning the future outcomes of their decisions. It is important for them to put together scenarios relevant to a particular investment project. There may be bi-modal or tri-modal probability distributions which reflect the more likely realisation of certain scenarios and indicate which scenar- ios should be investigated. An important aim of any information strategy is not so much to move decision makers from a higher to a The Investment Process and Decision Making: the Strategic Perspective 97
lower state of uncertainty, as to remove downside risk or exclude negative scenarios, and to discover ways of increasing, by deliberate action, any possible upside.
The level of uncertainty reflects the degree to which it is necessary to look into the future (for a relevant discussion see White 2004: chap. 4, Reading an uncertain future). The above table indicates the nature of the problem confronting decision makers in doing this.
The duration of the long and short term differ from industry to industry and from enterprise to enterprise, partly according to the length of life of an investment project.
The aim of reading the environment is to recognise opportunities and threats, whether preliminary to an early recognition of an oppor- tunity or building on existing opportunities to articulate a new project. It is the activity of identifying relevant information in the changing environment of the enterprise. It is also necessary to iden- tify who are the relevant readers, with the obligation, or rather oppor- tunity, of making the necessary reading. There are both inside and outside sources of information. Private consultancies and rating agen- cies have an important role to play. Reading involves four separate steps – scanning, monitoring, forecasting and assessing (White 2004).
The information gathered is incorporated into strategy thinking about emerging investment opportunities in order to articulate them as specific projects. It is also incorporated into the ensuing investment appraisal process. Reading is not a neutral process; it is of its nature a
‘political’ process intended to serve conflicting interests, involving the following steps:
• selection or the identification of relevant information, Table 6.2 The different time perspectives
Degree of stability State of uncertainty Information strategy Short term Predetermined Almost complete Exact
elements certainty prediction
predominate
Medium term Mixed strength Discrete options, Scenario or continuous building but limited range.
Long term Critical uncertainties Total ambiguity ‘Make the
predominate future’
Source: White (2004: 128).
• transmission by designated conduits of the relevant information to decision makers or strategy makers. These may be long and indirect,
• incorporation of relevant information into a strategy or, more specifically, into an investment appraisal process.
Different ways are discovered of reducing risk. This involves a number of processes – recognition of a threat, prioritisation of threats discov- ered and mobilisation of the resources to deal with the relevant threat.
The ‘political’ problems to be confronted include deliberate suppres- sion of the existence of a threat, reinforcement of an existing view which excludes the possibility of such a threat, and poor response to a threat, reflecting the weak bargaining strength of readers and fragmen- tation of decision making within the relevant enterprise. This means that any relevant information is likely to be distorted.
It is also necessary to identify opportunities. This requires identifying what are called ‘shadow options’ (Bowman and Hurry 1993: 763). Any information strategy must start by identifying all the available relevant options. The real options approach clearly identifies the nature of the information relevant to a desirable strategy. This is a matter of reading the environment for the relevant opportunities, since options come into existence when existing resources and capabilities allow preferred access to future opportunities (Bowman and Hurry 1993: 762). In the words of Bowman and Hurry, ‘Options ….. form the choice mecha- nism that underlies strategy’ (Bowman and Hurry 1993: 764).
It is only possible to value the options on the basis of relevant infor- mation. The specific information required might not be available to make the relevant valuations with any exactness. An option value ini- tially arises because of the uncertainty created by the passage of time and the ability, even the need, to delay investment expenditures. Time provides two particular advantages – the advantage of earning a return on the resources freed by deferred expenditures (the present value of the investment cost reduces with the length of the delay) and the pos- sibility that the world may change in a way that increases the value of the project. This assumes that future states are already given, whereas a significant difference between a financial option and a real option is that decision makers can strategically change the boundaries of both costs and revenues, deliberately increasing the upside and reducing the downside. The decision makers can also avoid the downside by not making an investment if unfolding events suggest that the outcome is a negative one.
This method allows the full value of an investment to be considered.
By plugging into financial valuations yielded by the market, it seeks to The Investment Process and Decision Making: the Strategic Perspective 99
impose a discipline on any investment appraisal, for example using the future prices of key products such as oil or gold. However, it does this in a way which avoids taking an attitude to risk tolerances. It also allows total risk to be considered, not just systematic risk, but also non-systematic risk, which cannot be diversified away with direct investments.
There are some difficulties in the use of the real options approach as an instrument for organising information in decision making:
• a lack of simplicity of the method. There are many attempts to show how the method can be explained to managers in a lucid manner,
• dealing with more than two kinds of uncertainty. If uncertainty is too great, the real options approach cannot be employed.
There is clearly a sequence of steps to move the approach beyond its role as a more systematic way of strategic thinking, in order to make it also a superior investment evaluation technique:
Qualitative result = identification of real options
↓
Approximate valuation = identification + elementary model parameters
↓
Exact valuation = identification + elementary model parameters + all the model assumptions met
A paper by Dimpfel, Habann and Algesheimer (2002) proposes a gradual applicability with differentiated prerequisites and results.
Some of the model assumptions which may not hold and therefore may prevent the movement to the third stage include:
• the existence of imperfect markets for real option rights and their valuation,
• the fictitious nature of the underlying assets and the nature of basis risk which reflects the failure of the asset chosen for the replicating portfolio to track accurately the value of the relevant project,
• the sharing of ownership of options among different market players (or stakeholders) – there is no clear maturity date since there is no control over others who might exercise the option,
• the interdependence of most real options attached to a particular project and, therefore, of their values.
It may be possible to define upper and lower limits to the values of the relevant options. Since it is impossible to include all possible variants and all possible scenarios – the computational requirements would be too great, the technique is based in most cases on a degree of qualita- tive judgement concerning the strength and significance of the rele- vant information. A strategic assessment should exclude from the appraisal most possible variants and concentrate attention only on certain scenarios.