Posted: September 2nd, 2022

I need 2 sets.Each set is 1 discussions and 2 replies

Understanding NPV & Real Options

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This discussion has 2 parts:

  1. Understanding what the net present value (NPV) tells us.
    • The NPV decision rule says to accept the project if the NPV is greater than zero. You perform a thorough capital budgeting analysis on a project that requires a $1,000,000,000 initial investment and calculate the net present value (NPV) as $1. Following the rule, you tell your boss she should accept the project. She laughs and says “do you think I would really invest $1,000,000,000 for a measly $1 NPV? You should be fired” How would you respond to her?
  2. Real Options
    • Give two examples of “real options” that you have come across in your professional life, or that may come up in projects in a business you wish to start, or that may come up in the projects at a company in which you hope to be employed.

Submission Instructions:

  • Your initial post should be at least 200 words, formatted and cited in current APA style with support from at least 2 academic sources. Your initial post is worth 8 points.
  • You should respond to at least two of your peers by extending, refuting/correcting, or adding additional nuance to their posts. Your reply posts are worth 2 points (1 point per response.) 

Classmate post 1

Part 1. In my opinion, any capital budgeting decision is to maximize the net present value of the projects which will create wealth for the shareholders of the firm. Even $1 NPV by investing $ 1 billion is creating value and the project should not be abandoned IF no higher alternate projects are present.

Part 2. One real option that my wife lived while she worked for a local construction company is that they were operating with huge losses and  unable to recover the company fixed costs. By doing a future forecasting they knew that they needed to make decisions like removing employees, future projects to have less cost. The company had done those actions but it came to the point where they only had the option to abandon. Another example of real options can be seen with local restaurants. There is one local smoothie place that saw it had high demands from one part of the city. the owners figured that other parts of town might enjoy his product as well so they decided to look for shareholders and share their success. This business has been very successful in our town for about 5 years so they felt safe to go in to different parts of town and still have the same success. This can be seen as option to expand.

Classmate post 2

My response would address my boss’s lack of confidence in the goal. I would remind her of the priority behind any capital budgeting decision is to maximize the net present value of the projects and therefore create wealth for the shareholders of the company. The concept of using NPV is standard (Berkovitch, 2004). Also, I would inform her that the $1 net present value does not mean that the profit is $1. This is the wealth generated for the shareholders after providing for the required return to the shareholders. Finally, I would tell my boss that a $1 net present value by investing a billion dollars is creating value, and thus if there is no other better opportunity, this project should be taken and considered as an opportunity to grow.

Real options may improve the net present value of a project (Moyer, McGuigan, & Rao, 2018). It allows managers to make decisions that change the value of capital budgeting decisions made in the present and future. In my personal experience owning a restaurant, when profits increased, we decided on the option to expand. We considered opening a new restaurant to grow our business. In my present venture, a midwifery practice, a real option that we have taken is the timing option. We have delayed investment in a home birth project to understand better the demand for outputs and the cost of inputs. In addition, our goal for choosing this real option is to get more information on the benefits and risks associated with home births and how this project is going to pan in the future.

References

Berkovitch, E. &. (2004). Why the NPV Criterion Does Not Maximize NPV. The Review of Financial Studies, 17(1), 239-255.

Moyer, R. C., McGuigan, J. R., & Rao, R. (2018). Contemporary financial management. Mason, OH: Cengage-Southwestern.

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