Investment Decision-making Using Optional Models

David Heller, David Heller

• Publisher: Wiley-ISTE
• Year: 2019
• ISBN:
  9781119687481
• Edition: 1
• Topic: Commerce
• Subtopic: Management

In order to create value, companies must allocate their resources effectively and evaluate investment alternatives. This book examines, from a theoretical and empirical point of view, how managerial flexibility can be integrated into investment decisions through the optional approach. Unlike the traditional net present value method, the actual options take into account indeterminate elements. These lead to unpredictable cash flows at the time of the investment decision, especially in the context of complex and risky projects. The book puts into perspective the use of optional models and their interactions. The different categories of options are the subject of practical applications, through analysis of investment decisions where uncertainty is growing. Therefore, studies make it possible to consider the flexible nature of investment choices by integrating new information and risk over time.

1
Risk and Flexibility Integration in Valuation

1.1. Introduction

The investment must be identified as an entry fee that provides access to future opportunities. Thus, the value of a project is not limited to the present value of anticipated cash flows, but must capture all the growth opportunities that will arise in the future. For this, real options offer a long-term vision. They have the advantage of incorporating future upside and downside cash flow opportunities through volatility representing the risk and, consequently, make it possible to incorporate the notion of flexibility into project management. In fact, depending on the cash flows, the project can, among other things, be carried, abandoned, strengthened or developed in sequence. Volatility is the key parameter of options, whether financial or real. Its usefulness lies in the fact that the value of derivative financial products or investment projects depends on the possibility of benefiting from favorable conditions or, otherwise, reducing losses. In practice, real options remain less used than the NPV criterion for determining the value of a project. However, Graham and Harvey’s (2001) and Hartmann and Hassan’s (2006) studies indicate that about a quarter of Chief Financial Officers (CFOs) surveyed use the real options approach to help them make investment decisions. Black and Scholes (1973), on the one hand, and Cox, Ross and Rubinstein (1979) models, on the other hand, form a basis for the valuation of investment projects by real options. Initially intended to enhance the value of financial options, these models are particularly relevant to evaluate a project taking into account a range of opportunities characterizing it.

After the realization of a pragmatic analogy as to the different parameters constituting these paradigmatic models, it is possible to apply the valuation of projects assimilated to real options. Thus, projects with growth options, abandonment options, combined options, sequential development options, or options for expanding or reducing the activity can be the subject of a dynamic and at least complementary analysis to that of the NPV criterion.

New parameters have been incorporated into the initial models in order to improve them by making them more precise. Thus, the notion of constant volatility established by Black and Scholes is questioned by some researchers who prefer a stochastic volatility with the objective of anticipating future developments in the price of the underlying. In addition, transaction costs complement the models by promoting a better definition of hedging strategies. Models with jumps...