Business schools in India still emphasizes NPV as the be all and end all of invesrment evaluation. And the state of practice is even more primitive! Payback period is an important factor in appraising projects and IRR or NPV is used only in select cases…… it appears that the superiority of these two remains effective only in pen and paper and in text books used in business schools! A question naturally arises that if it is the best among all, what explains it unpopularity among practitioners? We discussed a few of them in the previous article. Apart from those already, a relook at the treatment of risk in NPV deserves special attention.
Risk in NPV is accomodated in the discounting factor used in valuation. A project with higher risk calls for a higher discounting factor and one with lower risk employ a lower discounting factor. How rationale is this approach? Does investment not become myopic in this manner? Does in not discriminate against projects primarily on the basis of the fact that the risk profile of the project is bound to change over its lifetime and hence wattents the use of different discounting factor in different periods? And more importantly risk implies a variation on both sides of the mean, not just the lower side. How do we incorporate that in the analysis? How does we allow the valuation equation to incorporate the positive side of volatility as well? The NPV equation is ill equipped for these adjustments. In this model, risk is essentially bad and is to be discriminated against always.
Is NPV not very passive in its approach to investment analysis? It assumes only one possible state of nature in the future, the predicted state. But is prediction so certain an activity? And if it is so, why is it called prediction at all? Add to this it assumes that investments are a now or never proposition! Is that really the case? patent has a life of 25 years! And a company with an investment opportunity can always delay the investment to ensure lesser uncertainty: investment opportunities are essentially options, not obligations and they are most often than not discretionary! The NPV rule fails to appreciate this and the model is illequipped to incorporate the option element present in any investment proposition. Moreover it also fails to incorporate strategic aspects of an investment decision. Consider the case of television picture tube manufacturing companies. In the process of manufacturing those picture tubes, they got a foot hold in manufacturing computer monitor picture tubes as well. So the first step provided them an option to gain access to another related investment which was not in the horizon when the first decision to manufacture television picture tubes were undertaken! How would NPV incorporate something as complex as this? An investment today producing an option to create another product 15 years ahead? Difficult indeed. Consider a pharma company Ranbaxy. A perrinial problem that R&D companies face is how to value patents with a finite life and an uncertain future. Using NPV as an evaluation tool would produce a recommendation of ‘no go’ at each step, because higher uncertainity and more ‘what if’ situations would make even the best of cash flows look like nothing in the hands of the cruel discounting factor!
theoriticians and practitioners have increasingly had the realization that investment opportunities are essentially options, not obligations on the part of the investor or firm. This option element has close resemblances with those of financial options that are traded in the market! A financial option is a traded instrument providing the buyer of the instrument the right but not the obligation to buy or sell the underlying asset on or before a specified date at a price agreed upon at the initiation of the contract. Consequently, depending on what state of nature materializes the exercise of the option is determined. That is, if the market price of the asset in question is higher than the price mentioned in the option contract (called the exercise price) the option to buy is exercised, other wise the option expires useless! Similarly for an option to sell, the option is exercised if and only if the market price of the asset is lower than the contracted sell price. In both cases the investor faces an unlimited upside and a limited downside: the loss is limited to the price paid when entering the contract, beyond that there is no other loss.
Investment opportunities closely resemble options and the smiliarities between them are more profound than it appears at face value. The next article in this series looks at these similarities more closely.