A Real Options Approach for Entrepreneurs Making Decisions under Uncertainty

By Sale, R. Samuel; Atinc, Guclu | Issues in Innovation, Spring 2008 | Go to article overview

A Real Options Approach for Entrepreneurs Making Decisions under Uncertainty


Sale, R. Samuel, Atinc, Guclu, Issues in Innovation


COMMON ANALYSES

Net Present Value Analysis

NPV analysis seeks to determine the present value of a stream of future cash flows by discounting them based on a discount rate and the timing of the cash flows. These discounted cash flows are then summed together. If this summation is positive, NPV analysis suggests that a project should be undertaken. Conversely if the value is negative, NPV analysis suggests that the project not be undertaken.

Two fundamental ideas behind the discounting of a stream of cash flows are that more money is preferred to less money and that receiving money sooner is preferred to receiving money later. Because a rational person would rather have a dollar today than a dollar tomorrow, that person would only find an investment opportunity appealing if he or she expects to receive more than one dollar tomorrow in exchange for the investment of one dollar today.

The amount of the additional return, above the one-dollar initial investment, required to make an investment appealing varies from situation to situation based in part on the financial status of the investor. This discount rate is often set equal to the weighted average cost of capital (WACC). An entrepreneur's WACC is essentially the interest that he or she is charged on an "average" dollar. In order for an investment to be appealing, each dollar invested should have an expected return greater than the amount of interest that the entrepreneur pays on his or her debt. Otherwise, the entrepreneur would be better off to "invest" in the lowering of debt rather than invest in the project in question. The calculation of the WACC is concerned not only with interest paid on debt, but equity as well. The above explanation can be extended to consider dividend payments on equity, but the result is the same: Regardless of the source of capital, positive expected returns less than the WACC are not generally considered appealing.

Net Present Value Analysis, Uncertainty, and Risk

Critics of NPV state that it is inappropriate for use under uncertainty situations. Before this criticism is addressed, it is important to distinguish between uncertainty and risk. When a decision maker "lacks knowledge of what all the alternatives are, what the outcomes associated with each alternative are, or cannot assign probabilities to each of the possible outcomes," then the decision maker is facing uncertainty. When a decision maker "faces more than one alternative but knows all of the possible outcomes associated with each of the alternatives, and can assign probabilities to each possible outcome," then the decision maker is facing risk (Kroll, 2007, p4).

Critics of NPV analysis use two main arguments stating its inappropriateness for use in uncertainty situations. The first concerns how uncertainty is captured in the model. In NPV analysis, this is addressed using the discount rate. A firm's WACC is often used as the discount rate, but this is still more appropriate for decision making under risk than decision making under uncertainty. By definition, in uncertainty situations it may not be possible to estimate all potential cash flows and the probabilities of each of the cash flows occurring. Gilbert (2004, p49) makes this point and also points out that the discount rate is based on the variance of the cash flows and thus ignores skew and kurtosis.

The second, and more common, argument against the use of NPV analysis under uncertainty concerns the ability of management to respond to uncertainty over time. NPV analysis does not normally consider learning on the part of management or the impact of changes to the environment during the life of a project. This includes management's reaction to changes as uncertainties are resolved, as well as major changes to the business environment (Afuah, 2003, p231).

Because NPV analysis inappropriately models uncertainty and ignores the ability of the entrepreneur to respond to uncertainty over time, it systematically undervalues investment opportunities where there are high levels of uncertainty and management has the ability to respond to this uncertainty throughout the life of the project (Kogut and Kulatilaka, 1994, p52; Afuah, 2003, p231; Gilbert, 2004 p49-50; Wu and Tseng, 2006, p314; Wang and Hwang, 2007, p247). …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

A Real Options Approach for Entrepreneurs Making Decisions under Uncertainty
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.