Final Summary

Summary
The main purpose of the article, ‘Capital Projects as Real Options: An Introduction’, is to suggest a
methodology for separating asset-in-place from its growth options to evaluate the capital budgeting
projects. This approach relies on option pricing theory such that it is an add-on to the DCF analysis and
helps investors arrive at a decision after thorough analysis. The article particularly draws attention to
investment proposals as call options. This highlights that the owner has the option to buy the underlying
asset at low price level and make a profit when the price rises. The main motive behind this option is
speculation of a price rise which is similar to what one ideally expects from an investment decision.
Failure to view the investment decision alongside its options can lead to poor decision. In reality,
however, projects are often composed of asset-in-place and growth options are attached to it. The option
is primarily of investing or not investing based on good news or bad news. Consequently, evaluating such
projects based on DCF analysis alone can be misleading. Hence, to evaluate such complexed projects, the
article assumes that the reader is equipped with knowledge of basic option pricing and capital budgeting
techniques which would assist the construction of a map to study the relationship between a project’s
NPV and call options’ value.
A call option is basically a contract that gives the buyer a right to purchase 100 shares at a set price
known as exercise price. A financial expert can determine a call option by using analogies like initial
expenditures corresponding to exercise price, riskiness of the project corresponding to variance and
similar mapping of terms.
In order to compare option valuation to traditional DCF-based capital budgeting, lets begin by our
understanding of NPV. The traditional approach states that NPV is the present value of the difference
between expected net cash flows and the initial capital expenditure, and the criteria is to accept the project
if it has a positive NPV. This can also be expressed in quotient form which is, (Net cash flows/ Capital
expenditure), and the criteria now is to accept the project if NPVq is greater than 1.
By using the NPVq we can explain how to analyze a corporate project using option valuation. Since net
cash flows equal the stock price(S) and capital expenditure equals exercise price(X), hence S/PV(X) can
be used to decide whether to choose a call option at expiration or not, using the same criteria i.e accept
the project if NPVq is greater than 1.
When a decision has to be made immediately, a call option/project can be analyzed through simple DCF
tools but if we can wait and observe the project, then the situation is similar to a call option but in this
case NPVq and variance are also taken into account. Multiplying the variance by time period gives
cumulative variance which is a measure of how much things can change before a decision is to be made.
In order to asses a project with a non-zero time period and variance, a DCF analysis should be avoided
and rather the Black Scholes Model should be referred to determine what percentage is the value of the
option compared to the value of the underlying asset.
Prior to expiration the NPV and NPVq may show differences; however, these two tend to congregate onto
one deduction as at expiration time either NPV > 0 and NPVq > 1 or NPV < 0 and NPV q < 1.
With NPVq > 1 there are projects with both negative and positive NPVs, for this region the locus curve
drawn: starting from cumulative variance = 0 and NPV q = 1, is equivalent to NPV (exercise now) = 0.
Options at the very top of the call-option space have NPV>0 and are ‘in the money’ and they must be
undergone instantly. (Shaded green in the graph below).
Just below exercise now region but falling above the locus curve are the points having NPV>0 and
NPVq>1. For these options, the manager advises to wait if possible although earlier the execution, more
desirable because waiting results in the erosion of underlying asset due to several reasons such as:
competitors’ actions, technical and demographic changes. Nonetheless, early action on these options faces
the opportunity cost of interest on exercise price. Therefore, the management needs to evaluate this trade-
off before devising the best course of action. (Shaded blue in the graph below).
The options lying below the locus curve have NPV<0 and NPV q>1, are promising and should be given
time for most of them are anticipated to enter ‘in the money’ region if these receive active attention of the
management. (Shaded red in the graph below)
As shown in the graph below as well:

Now, if we extend the logic previously explained and delve into more depth, let’s divide the same figure
into further three more parts. Part I, II, and III represent when NPVq >1 whereas, part IV, V, and VI
represent when NPVq <1. It should be noted that all these 6 parts represent 6 different decisions; and to
explain these decisions let us consider the analogy of a tomato garden where Financial Managers are
Gardeners. The diagram presented below lists down why certain decisions shall be made along with
reasoning:
The key to understanding why certain decisions were made is to understand the combination of NPVq
and Cumulative variance. Higher the cumulative variance, the higher the option value. Very Low
cumulative variance has only 2 outcomes either exercise quickly (Money is in) or leave the option
(Money is out) because the time to expiration is very near. Furthermore, High cumulative variance gives
us the margin to wait and observe and make our decision depending upon NPVq I.e. if NPVq >1
promising project and NPVq <1 not much promising; however, the decision may vary after some time (t)
has passed. And in the final combination where Cumulative Frequency is mild, exercise early if NPVq >1
(depending upon the situation), and if NPVq <1 the project is very doubtful.
Real World problems are really complex. It is necessary to simplify them to an extent and solve them in
certain frameworks, approximate the viable options, and the apply back the complexity and interpret
them. For this purpose, some routes are available. The project can be simplified by looking to the main
uncertainty that drives the problem. Another approach is to simplify the project in such a way that it either
dominates or is dominated by the real project. This will help in finding either the lower or upper limit
values of the project and the project can judged accordingly. Next it is required to estimate the volatility of
the project. One approach to this problem is to take an intelligent guess usually by finding the correlation
between beta and alpha values. The second approach is to gather more data resulting in a more nuance
approach. Third, variance can also be simulated though spread-sheet projections such as Manty Carlo
simulation. Next models and distributions checking come up. Probability distribution can help assess the
riskiness of a project. By looking at the direction in which the distribution is biased it can be judged
whether the projected value is upper or lower bound limit. However, this also depends on the model and
for some options (worlds), brute force technique would be needed as the variables attributed increase and
only high-speed computers can formulate the decision trees. The last part is applying back the layers of
complexity to finally interpret the problem in the real world. These different plans if put forth in an
efficient way can result in approximately accurate valuation of the project and help on the decision.

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