Investment Decision
A simple investment decision: Optimal timing
Standard methods, as the Net Present Value (NPV) or Scenarios, advise decision makers to invest whenever the NPV>0. Yet, in practice decision makers do not always follow this rule. One reason is that an investment requires irreversible costs: a firm cannot fully recover the investment it makes in case it wants to disinvest. For example, it may need to buy machinery or build infrastructure that can only be used for the purpose of the investment, and thus, cannot be recovered. Another reason is that future is uncertain: every investment has risk, and if the NPV is low, there is little margin to accommodate bad outcomes in the future. And finally, the firm can usually wait to make the investment: it has the flexibility to postpone investment and check how business conditions evolve. We study the relevance of these factors in a simple applied investment example.
The relevance of Real Options Valuation (ROV) for investment can be better understood graphically. In Figure 1, we plot five possible paths for (projected) cash flows: two good scenarios, an average scenario, and two bad scenarios. If the firm does not invest today, it has the opportunity to check how cash flows evolve, and make a more informed decision in the future. The question is: should the firm invest today or wait?
This project is more attractive: average returns (cash flows) are higher and risk is smaller. It is a better candidate for investiment, but there is still risk. To accurately valuate this project, and determine if it is worthwhile to take the risk and make an irreversible investment today, it is required a much more detailed analysis. It requires more advanced techniques: it requires the techniques of Real Options Valuation; it requires the techniques employed by Watson & Noble.
Value
Figure 1
Time
Moment of decision
In this case, there is high risk that a bad outcome occurs, implying a negative NPV. But if it waits, the firm can avoid the negative NPV. So the Real Option to wait has a value: the firm can postpone decision, and avoid making irreversible investments with negative payoffs. Yet, uncertainty is always present. In the future, even if (estimated) cash flows increase, they can start decreasing. So when should a firm invest? What is the rule of investment suggested by Real Options Valuation?
General ROV rule of Investment: the firm should only invest today when the value gain of investing today exceeds the value of waiting (the value of the Real Option to delay investment). In other words, the firm should only invest today if the estimated NPV is high enough such that the investment more likely generates a positive payoff in the future. Real Options Valuation determines just that: Real Options Valuation analyzes the relative importance of value drivers, and determines the minimum NPV required to prefer to invest today rather than wait.
In Figure 2, we present another case in which the expected cash flow is higher than in the previous case. There are still two good scenarios, one average scenario, and two bad scenarios, but only one of the bad scenarios implies a negative cash flow for the near future. Is the decision any different?
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Figure 2
Time
Moment of decision
A simple investment decision: Other decisions that matter
Besides determining optimal timing, Real Options Valuation can also incorporate other relevant strategic decisions in the value of today’s decision.
Let’s consider two projects that are in all respects equal (estimated cash flows, risk, etc.) but one: in case business conditions deteriorate, the firm cannot recover any part of its investment in Project A, but it can sell the machinery (at a discount) and reapply the infrastructure if it invests in Project B. An experienced decision maker will obviously prefer project B because it offers a more attractive Real Option to Abandon.
Yet, the decision is trickier when the two projects also differ in other aspects as estimated cash flows and risk. If Project A has higher expected cash flows, what is, then, the best project? This depends on the difference in cash flows, and on the probability that business conditions reverse and force the firm to abandon the business.
The relative importance of the multiple value drivers in the future can only be assessed using Real Options Valuation. Only then, the decision maker can make a more informed decision to generate more value for the firm.
There are other options that matter. For example, the Real Option to Expand. Let’s consider two projects (A and B) to invest in infrastructure to produce a given widget. The infrastructure built in project A allows the firm to produce enough widgets for its current demand. But the infrastructure built in project B allows the firm to produce more than its current demand.
In case demand rises, the firm requires further investment if it proceeds with project A, but not if it proceeds with project B. What is the best project? If the investment cost is the same for both projects, the best project is Project B. But if investment costs differ, the optimal project is not so clear. This depends on the probability that demand rises, on the difference between the investment costs between the two projects, and on the investment cost required to increase capacity in project A if demand rises. This, again, can only be assessed using Real Options Valuation to determine the value of the Real Option to expand.
The Real Options to wait for information, to exit, to expand, and others are part of the strategic thinking of an experienced decision maker. Real Options Valuation creates value by accurately translate strategic thinking to numbers. Real Options Valuation helps decision makers make better and timely decisions.
