Up to now, we have assumed that cash flows in a capital budgeting project occurred out to some horizon and then were discounted to obtain their present value. However, investment projects are not necessarily set in stone once they are accepted. Managers, can, and often do, make changes that affect subsequent cash flows and/or the life of the project. Slavish devotion to traditional discounted cash flow (DCF) methods often ignores future managerial flexibility that is, the flexibility to alter old decisions when conditions change.
The presence of managerial, or real, options enhances the worth of an investment project. The worth of a project can be viewed as its net present value, calculated in the traditional way, together with the value of any option(s).
Project worth = NPV + Option(s) value ——–Equation 1
The greater the number of options and the uncertainty surrounding their uses, the greater the second term in equation 1, and the greater the projectâ€™s worth. For now, it is sufficient to say that the greater the uncertainty, the greater the chance that an option will be exercised, and hence, the greater the optionâ€™s value.
The types of managerial options available include,
1. Option to expand (or contract) — An important option is one that allows the firm to expand production if conditions become favorable and to contract production if conditions become unfavorable.
2. Option to abandon — if a project has abandonment value, this effectively represents a put option to the projectâ€™s owner.
3. Option to postpone — For some projects there is the option to wait and thereby to obtain new information.
Sometimes these options are treated informally as qualitative factors when judging the worth of a project. The treatment given to these options may consist of no more than the recognition that â€œif such and such occurs, we will have the opportunity to do this and thatâ€?.
Managerial options are difficult to value than are financial options; you will find that the formulas for financial options taken up. Often do not work when applied to managerial options. Rather, we must resort to less precise approaches such as decision trees (i.e. diagrams of decision problems) and simulations.