Academic journal article Academy of Accounting and Financial Studies Journal

Using Real Option Analysis to Improve Capital Budgeting Decisions When Project Cash Flows Are Subject to Capacity Constraints

Academic journal article Academy of Accounting and Financial Studies Journal

Using Real Option Analysis to Improve Capital Budgeting Decisions When Project Cash Flows Are Subject to Capacity Constraints

Article excerpt

INTRODUCTION

Net present value analysis requires a financial manager to forecast expected net cash flows and discount them using an appropriate required return. Some projects have cash flows that are limited by capacity constraints. These constraints may also interfere with obtaining estimates of expected cash flows. For example, a real estate developer evaluating the feasibility of developing a hotel in a particular market may have accurate information about occupancy rates for similar properties already located in that market. However, on those days that the existing properties all operate at capacity, it is not possible to observe actual demand. Basing the valuation on an assumption that the proposed project can capture a portion of observed demand will underestimate the actual value of the project. Even when an analyst has good information about total demand, if the nature of the project (e.g., the size of a facility or the nature of its production process) create a limit on the revenue that can be realized in any particular period, a valuation that relies on demand without considering the effect of the constraint may overestimate project value. Figure 1 illustrates how a capacity constraint limits the ability to observe and/or to generate revenue from actual demand. The demand appears on the x-axis and the cash flow associated with the demand on the y-axis. When there is a capacity constraint at K, demand exceeding that level appears as demand of K units and revenue that can be generated is capped at [CF.sub.K].

One way to include the effect of a capacity constraint when valuing a project affected by the constraint is to use real option analysis. The effect of the capacity constraint illustrated in Figure 1 has the same pattern as the payoff profile for an option. This suggests that option pricing principles may be useful provided the option can be identified and appropriate values determined for those variables needed to value the real option.

APPLICATIONS OF REAL OPTION VALUATION

The real option literature suggests that real options analysis may be more accurate than net present value for: mineral production projects (Davis, 1996; Mann, Goobie and MacMillan, 1992; Sick, 1990; Palm, Pearson and Read, 1986; and Brennan and Schwartz, 1985); real estate development (Rocha, Salles, Alcaraz Garcia, Sardinha and Teixeira, 2007; Williams, 1991; and Titman, 1985); and mergers and consolidations (Lambrecht, 2004; and Smit, 2001). The real option characteristics examined in connection with these projects do not consider the effect of capacity constraints.

In other application of real option analysis, even when the project can be appropriately valued using net present value principles, some changes in the business environment create fundamental changes in a business that can best be valued using real option analysis. Trigeorgis, 1993, shows how option pricing improves valuation from net present value alone when a project can be expanded in response to greater than expected demand. McDonald and Siegel, 1985, and Brennan and Schwartz, 1985, demonstrate use of option analysis to value an option to shut down. Other research uses real option analysis to value the option to abandon (Myers and Majd, 1990) or to wait and begin the project at a later date (Quigg, 1993). Real option analysis has also been used to determine the optimal initial investment when there may be value to expanding or reversing an investment in response to changes in demand (Abel, Dixit, Eberly and Pindyck, 1996). See also Bockman, Fleten, Juliussen, Langhammer, and Revdal, 2007.

These foregoing studies consider the effect of a single future event that fundamentally alters future project cash flows and hence the project's value. This is analogous to the payoff on a financial option depending on whether it is in- or out-of-the-money based on the market price at a future date. Additionally, real option analysis is useful when a projects' periodic cash flows have option characteristics. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.