the loss is the possibility that the net present value which is currently positive becomes negative.
Such a view assumes there are variants of the project which differ by their timing. By distinguishing the different variants, the real option approach puts a value on the ability to consider different options. It is necessary to determine the differing threshold levels of net present value which would justify outright rejection and immediate investment. It is necessary to value any option in order to estimate an expanded net current value. Otherwise if there is a desire to retain the positive net current value rule, the opportunity cost approach should be adopted which requires an addition to the conventional investment cost.
The real options approach requires identifying the information rele- vant to a investment decision and necessary to value the advantage of flexibility in the timing of an investment. The two methods which are commonly discussed in the literature, the Black-Scholes formula4and the binomial method (see chapter 11), identify five main factors which influence the value of a real option, analogues of those used in valuing a financial option.
Table 5.1 Mapping an investment opportunity onto a call option
Call options Variable Investment opportunity Effect on value Stock price S Present value of a project’s +
net cash flow
Exercise price X Expenditure required to – acquire project assets
(the investment cost)
Time to maturity t Length of time the decision + may be deferred
Riskiness of project σ2 Variance of returns assets + Risk-free rate Rf Risk-free rate (time value +
of money)
The general approach can usually handle two types of uncertainty, three at most, the Black-Scholes formula less.
The first task is to identify the underlying asset. The approach seeks to link the estimation of relevant values to market valuations, where possible. It is often difficult to find an asset sold on the market which exactly reflects the project. The problem is avoided by creating a syn- thetic portfolio with the same characteristics as the project. The under- lying assets for a real option are portfolios of securities traded in the
financial market with an equivalent risk, whose fluctuations are used to determine the value of the option. For example, if it were an invest- ment in expanding a semi-conducting manufacturing facility, the option value reflects the future price of chips as the underlying assets.
Or the underlying asset for oil exploration is the appropriate oil futures contract or an index of such contracts.
Traded contracts price in a convenience yield while spot prices do not.
There are non-contingent cash flows which attach to the underlying asset, some positive and explicit, such as rents, dividends, interest, royal- ties or license payments, or implicit, benefits such as convenience yields, some negative and explicit (reflecting inventory held for what Keynes called the precautionary motive), losses such as storage costs, taxes, licensing or royalty fees, insurance cost loss from perishable damage.
These are significant for certain kinds of investment. Spot prices reflect supply and demand, whereas the value of assets, such as futures con- tracts or other options, reflects information about relevant cash flows.
Despite the effort to link real options to financial markets, the usual method of valuing the underlying asset is to use the discounted value of free cash flows generated by the sales of the chips or of the oil.
The further into the future that the investment project is imple- mented, the more difficult it is to estimate its cost. The time to maturity is a variable; it is the time that the enterprise retains some monopoly control over the source of competitive advantage, the time allowed by the expiry of a contract or a patent or simply the period during which a competitive advantage exists since it takes time for competitors to imitate the competitive advantage. It is not easy to know how long such an advantage might last. The reduction in the time to maturity is a fresh source of uncertainty. Generally, the longer the time to maturity, the greater the uncertainty faced by the decision makers.
Risk is the volatility of the cash streams generated by the project. It can be either the variance of a probability distribution, usually assumed to be normal, or the full range of possible returns, the gap between the most optimistic and the most pessimistic forecasts. The basis for estimating such a volatility may be existing historical data or even, and preferably for some, the volatility of a traded option relevant to the underlying asset.
Volatility is related to a relevant time unit. It is common for the pricing of contingency claims or options to take account of a further source of uncertainty – unpredicted extreme events, specifically their frequency of occurrence and severity of impact. How this is done is discussed later.5The risk-free interest rate is that which reflects the value of time. There are various ways of valuing real options and of incorporating the real options approach into the net present value formula, discussed in chapter 10.
The Investment Process and Decision Making: the Financial Perspective 83
6
The Investment Process and Decision Making: the Strategic Perspective
Strategic analysis provides a framework where the value lies not so much in providing answers, but rather in the guidance of decision making, the comparison and evaluation of alternatives, and studying the source of business successes and failures.
(Rogers 2002: 35) This chapter turns from the project level to the enterprise level, mainly because an appraisal which considers an investment project in isolation is inadequate. An enterprise perspective is necessary. The chapter, therefore, adopts a strategic perspective on investment deci- sion making, one which places the appraisal of a single investment project in the context of the overall enterprise strategy, including its relationship with other projects – past, present and future. Such a per- spective stresses the role of the enterprise as a maker of strategy. It is consistent with a view which interprets most strategy as emerging from a learning process. It also discusses the strategic risk arising from the strategy of other players before presenting an expanded version of net present value and a decision rule which takes full account of uncertainty. It follows up with a review of the requirements of a rele- vant information strategy. The chapter concludes with an analysis of a critical aspect of strategy, the appropriate mode of entry to be adopted into international business transactions.
There are six sections in this chapter:
• The first section explores the different ways of interpreting the nature of the enterprise.
• The second section shows the importance of strategy in the interac- tion of investment projects.
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• The third section considers strategic risk, that is, the negative impact which competitors’ decision can have on an enterprise.
• In the fourth section there is a discussion of how an individual investment project can be properly appraised only within the context of the overall strategy of the enterprise.
• The fifth section concentrates on the role of a risk control strategy, particularly an information strategy, in the overall strategy of an enterprise.
• The sixth section illustrates how the choice of direct investment as a mode of entry into international business transactions is influenced by risk.