The DCF valuation assumes that a firm adopts a passive approach towards its real assets. It ignores the options embedded in real assets. Remember that the DCF method was initially developed for valuing bonds and stocks. Investors in these assets are generally passive. Barring exceptional circumstance, they can hardly do anything to enhance the interest or dividend the get from financial assets.
New look at the real assets in which firms invest. Smart managers know that they can add value to those assets by exploiting options embedded in them. These options enable to magnify gains and curtail losses.
Taxonomy of real Options:
There are several important options found in capital projects. Every option may be classified as follows:
Investment Timing Option: The firm may invest in a project now or defer the investment by a year or so. Delaying the investment may help in resolving some uncertainly about the value of the project. The ‘wait and watch’ option is a common real option.
Expansion Option: If the initial project does well, the firm has the option to make follow on investments aimed at expanding capacity. In many cases, capacity expansion can be achieved at a modest cost by making de-bottle necking investments.
Growth Option: A firm may undertake an R&D program, or build a small plant to serve a new market, or make a modest strategic investment decision in a new line of business. Per se, each of them may be negative NPV investment. However, such am investment provides Michael Porter calls it as a ‘beachhead’ as it opens up new opportunities in future. For example, Procter and Gamble acquired the Charming Paper Company which served as a beachhead to launch a cluster of products like disposable diapers, paper towels and bathroom tissues.
Shut down option: A project may be temporarily shut down if it is economical to do so. For example, an iron ore mining projects may be closed for a while if the output price of the iron ore is depressed. In general shutdown options are more valuable when the variable costs are high. A shutdown option reduces the downside risk of the project.
Abandonment Option: If the project does not perform well and there is very little promise for improvement, the firm can consider the exit option. The firm need not continue with an uneconomic activity indefinitely. An abandonment or exit option, like a shutdown option, reduces the downside risk of the project.
Flexibility Option: Apart from the options that naturally exit in most projects, managers can incorporate flexibility on designing the project. The designed-in options may take the form of input flexibility options, and output flexibility options.
An input flexibility option allows firm to switch between alternative inputs For example an electric power plant may go for a flexible dual fuel boiler which can switch between gas or oil as fuel, depending on which source of energy is cheaper at a given point of time.
An output flexibility options allows a firm to alter the product mix. Oil refineries, for example are typically designed with the flexibility. This permits them to switch from one product mix to another, depending on which product mix is the most profitable at a given point of time.
Relative Values of cash Flows and Options:
A variety of analytical and numerical methods have been proposed for valuing real options. While these methods are too advanced for this article, the key insights provided can be combined with well formed judgment to get broad sense of the value of real options.
In general, real options are more valuable when:
1. The environmental uncertainty is high
2. The degree of managerial flexibility is high