The principles underlying the present value formula are the same for an enterprise as for an individual project: the managers of an enter- prise are interested in the difference between the position the enter- prise will be in if it goes ahead with a project and the position it will be in if it does not (Hull 1980: 3). They are interested in any future incremental cash flows generated by a project. An appraisal involves comparing the cash flows which will occur if the project is undertaken but will not occur otherwise, and the cash flows which will occur if the project is not undertaken but which will not occur if it is under- taken. The relationship between different projects influences these net flows.
The capital budgeting and strategic approaches to investment deci- sion making were developed separately (Myers 1984, Trigeorgis 1996:
7–9) and widely regarded as incompatible approaches. There, therefore, emerged two streams of thinking about resource allocation within the enterprise, including the nature of investment decisions (Trigeorgis 1996: 7–8)). One is the capital budgeting approach which decentralised decision making to the project level and concentrated on the discount- ing of particular cash streams to a present value. The other is the strat- egy making approach which focused on the creation and maintenance of overall competitive advantage in the longer term. The previous chapter has illustrated one way of reconciling the two approaches, through the real options approach, which makes possible a valuation of the benefits which the opening of strategic options can bring to a particular project. The real options approach is partly a tool which assists in the appraisal of individual investment projects, but also an expression of a strategic approach which affects all business decisions.
The Investment Process and Decision Making: the Strategic Perspective 87
The emphasis on flexibility not only focuses attention on identification of the full range of choices open to those making a strategy but also emphasises the particular interpretation of strategy as emergent strat- egy, which has at its centre a learning process in which ignorance and uncertainty are dissipated over time, sometimes by deliberate action and sometimes by a simple unfolding of events. Learning can be directed to developing particular options and not others.
Any strategy has as a starting point a set of options for the use of the investment funds available to the enterprise. At the core of any strat- egy are investment projects, some already up and running and some at an early stage in their development. The return from any investment project reflects in part the context created by other investment projects already accepted. There are significant interdependencies between existing investment projects and between present projects and future projects. The typical portfolio of projects of a healthy enterprise com- prises both, projects at various stages in the life time of a product, process or even industry. The strategy is the mechanism for selecting appropriate investment projects and for allocating the resources required to implement them.
There are two main kinds of projects, operational and strategic. The former, characterised by good profits but limited growth potential, generate most of the existing profits and the latter, characterised by poor profits, if not losses, but great growth potential, create the potential for maintaining performance in the future. Classical strategy describes a strategy in which most projects are of the former kind.
Since strategy looks to the future it is about projects which open up the possibility of future profits. Much of the market value of an enterprise, particularly in such fast-changing industries as electronics, communi- cations, biotechnology or pharmaceuticals is accounted for by growth potential rather than current cash streams (Myers 1984, Smit and Trigeorgis, 2004: 6–8). The strategic projects spawn both operational and further strategic projects, whereas the operational projects only spawn to a slight degree (Kasanen 1993).
Embedded in alternative investment projects are options (Kemna 1993).
At any time a strategy consists of various options, only some of which will be exercised. In the words of (Foss 1998: 10): ‘Optimal flexibility corre- sponds to the plan of action that enables the firm to acquire the set of options that maximise the net present value of the firm.’ Strategy needs to be flexible enough to take account of uncertainty and is emergent, reflecting learning done at all levels of the enterprise. The interdependence of investments must be recognised in a strategy consisting of linked options. Strategy stresses their compound nature, the fact that future suc-
cessful projects depend upon the realisation of previous options. For example, a successful pharmaceutical enterprise has projects at various stages of development, from the initial concept, through various clinical trials, to the process of regulatory approval for a new drug or process and its marketing. Since early project stages have a negative net present value, all the value is generated in the final instalments.
The previous chapter sidestepped the issue of interdependency, the possibility that a project influences the cash flows of other projects. A project might add value to other projects undertaken by the relevant enterprise, or create a potential for adding value in the future. There are two kinds of interdependency. The first involves synergies of revenue and cost between existing projects. It is possible to refer to such synergies as realised interdependencies. Various economies of scope fall under this heading. Any shared facility has the effect of reducing costs for other projects. A branding exercise has a ‘rub-off’
effect on any products or services sold. This term can be denoted RI, and included in an expanded formula.
On the other hand, there are unrealised interdependencies which are common. The existence of unrealised interdependencies generate value as real options, which can be grouped into three main kinds as shown in the table below.
The existence of such options has a significant value for a strategy.
Any research and development project is analogous to an option, since it can create a valuable opportunity without committing the enterprise to investing in the commercialisation of that opportunity. Some of the options are more tactical than strategic, notably those described as in- surance options. Because of the existence of switching costs for the insur- ance options, there is a significant degree of path dependence for the cash streams in any relevant strategy.
The Investment Process and Decision Making: the Strategic Perspective 89
Table 6.1 A classification of options
Learning options Option to wait
(before investing) Option to ‘stage’ an investment – to make it in instalments
Growth options Option to innovate (while and after investing) Option to expand Insurance option Option to contract
(while and after investing) Option to switch inputs or outputs
Option to abandon or shut down temporarily
The full option value can only be estimated within the context of a specific strategy which has identified all the possibilities. In the words of Copeland and Antikarov (2001: 5): ‘we would go as far as to say that NPV systemically undervalues each project’. It does this because that technique ‘fails to capture the value of flexibility’ (ibidem: 13). A further term should be added to the expanded net present value formula, one denoted UI (unrealised interdependencies). It is the value of all the options which attach to a given investment project, not a simple sum of those values since some options are mutually exclusive.
For the sake of completeness the existence of both positive and nega- tive externalities should be recognised. The existence of interdepen- dencies provides a good reason for adopting some projects with a negative net present value or rejecting other projects with a positive value.