A Real Options Approach for Entrepreneurs Making Decisions under Uncertainty
Sale, R. Samuel, Atinc, Guclu, Issues in Innovation
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). …