Real Options in Capital Budgeting

Real Options in Capital Budgeting

The usual capital spending or budgeting techniques guide financial managers of companies in making accept or reject decisions about specific projects and assets. They do not guide these managers in areas related to the project after it has been initiated. The managers using only these techniques would not be able to change their decisions when the project has started. One assumption of capital budgeting is that if a project is accepted it will continue without any consideration of actual cash flows. Real options play a vital role for managers in this area. The managers have options through which they can adjust projects according to the changing trends of the market. These options are often referred to as real options, managerial options or strategic options. The managers can adjust projects according to change in economical conditions, market competition and varying growth trends using real options. The managers have to recognize the options available in a project and generate newer options for each project. The various real options available in a project include investment timing options, abandonment options, growth options and flexibility options (Brigham & Ehrhardt, 2001). The capital budgeting techniques offer two alternatives for management either to accept the project or reject it.

There is another option available with these two alternatives which is investment timing, where the investment in a project can be delayed to a future date. For example suppose IBM plans to manufacture computers based on advanced technology, Microsoft has the option to immediately start creating the software that would be required for the new computers or delay the development to a later stage when IBM is ready to launch its computers in the market. This option is viable only if the delay compensates for any loss in market share of the software. The second option available to managers during a project is the abandonment option which enables them to abandon or discard any project before its life when it starts to have an adverse affect on the project’s cash flows. The abandonment option is used when the cash flows of a project are affected adversely by changing environments. For example a project which had a positive NPV is started but after two years due to severe economic conditions the projects cash flows become negative then the managers can decide to abandon the project at this point if the option is available. The growth option enables managers to enhance projects with growth in demand and sales. The managers can decide to add more components to a project or make it more geographically diversified to meet the increase in demands and benefit from new geographical markets.

The flexibility option makes projects more flexible to changing trends and market conditions. Suppose a company is planning to setup a manufacturing plant for shoes which would produce sports shoes for various age groups. Though the NPV of the future cash flows is positive, the management has an option to establish a plant with some extra capital spending to make it flexible to shifts in demand of shoes. If the demand for sports shoes declines and that for formal shoes rises, the company would be able to cope with this shift in demand by increasing the production of formal shoes and decreasing sports shoes production. The real options available to managers can be evaluated by various methods which include the following: Using the traditional capital budgeting techniques and assuming the values of real options to be zero, Second valuation technique is to use the same traditional approach and include a qualitative identification of real options, Third techniques is to use decision trees, and the last technique is to adapt the financial option model and value real options specific to various projects. The most common technique for valuing and analyzing real options is to apply the Black-Scholes model for call and put options (Brach, 2003). The management of the company can diversify the capital spending structure by applying any one of the real options in various scenarios.

References
Brach, A. M. (2003). Real Options in Practice. New Jersey: John Wiley & Sons, Inc.

Brigham, E., & Ehrhardt, M. (2001). Financial Management: Theory and Practice 11th Edition. Florence: South-Western Educational Publishing.

Calculate the price
Make an order in advance and get the best price
Pages (550 words)
$0.00
*Price with a welcome 15% discount applied.
Pro tip: If you want to save more money and pay the lowest price, you need to set a more extended deadline.
We know how difficult it is to be a student these days. That's why our prices are one of the most affordable on the market, and there are no hidden fees.

Instead, we offer bonuses, discounts, and free services to make your experience outstanding.
How it works
Receive a 100% original paper that will pass Turnitin from a top essay writing service
step 1
Upload your instructions
Fill out the order form and provide paper details. You can even attach screenshots or add additional instructions later. If something is not clear or missing, the writer will contact you for clarification.
Pro service tips
How to get the most out of your experience with MyhomeworkGeeks
One writer throughout the entire course
If you like the writer, you can hire them again. Just copy & paste their ID on the order form ("Preferred Writer's ID" field). This way, your vocabulary will be uniform, and the writer will be aware of your needs.
The same paper from different writers
You can order essay or any other work from two different writers to choose the best one or give another version to a friend. This can be done through the add-on "Same paper from another writer."
Copy of sources used by the writer
Our college essay writers work with ScienceDirect and other databases. They can send you articles or materials used in PDF or through screenshots. Just tick the "Copy of sources" field on the order form.
Testimonials
See why 20k+ students have chosen us as their sole writing assistance provider
Check out the latest reviews and opinions submitted by real customers worldwide and make an informed decision.
business
Great job
Customer 452773, February 13th, 2023
Business and administrative studies
excellent job thank you Your Score 166.25/ 175- A 1. Current Culture 15% of total grade 18.37 Criterion "1. Current Culture" has textual feedback Criterion Feedback I see interesting points, though, in general they are not about the culture.
Customer 452773, June 4th, 2023
Humanities
Thank youuuu
Customer 452729, May 30th, 2021
Business and administrative studies
excellent, got a 100
Customer 452773, May 17th, 2023
BUSINESS LAW
excellent job made a 93
Customer 452773, March 22nd, 2023
Human Resources Management (HRM)
excellent
Customer 452773, June 25th, 2023
Leadership Studies
excellent job
Customer 452773, August 26th, 2023
Human Resources Management (HRM)
excellent job
Customer 452773, June 25th, 2023
Psychology
Thank you!
Customer 452545, February 6th, 2021
Leadership Studies
awesome work as always
Customer 452773, August 19th, 2023
Sociology
THANK YOUUUUU
Customer 452591, March 18th, 2021
Leadership Studies
excellent job as always
Customer 452773, September 2nd, 2023
11,595
Customer reviews in total
96%
Current satisfaction rate
3 pages
Average paper length
37%
Customers referred by a friend
OUR GIFT TO YOU
15% OFF your first order
Use a coupon FIRST15 and enjoy expert help with any task at the most affordable price.
Claim my 15% OFF Order in Chat
Close

Sometimes it is hard to do all the work on your own

Let us help you get a good grade on your paper. Get professional help and free up your time for more important courses. Let us handle your;

  • Dissertations and Thesis
  • Essays
  • All Assignments

  • Research papers
  • Terms Papers
  • Online Classes
Live ChatWhatsApp