Posted: September 2nd, 2022
Understanding NPV & Real Options
This discussion has 2 parts:
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.
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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