Principles of Corporate Finance with Cdrom
Principles of Corporate Finance with Cdrom
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Businesses are continuously confronted with decisions that have to be made under different degrees of uncertainty. The project investment strategy adopted by a company will have a major impact on its future growth and profitability. Managing a company is therefore primarily about managing uncertainties and understanding the relationships between the risk and the opportunities in each business proposal.This paper discusses the inadequacies of net present value (NPV) modelling in dealing with the management of uncertainties, which are common in ‘high-tech’ investments. NPV modelling deals with uncertainties by increasing the discount rate, which reduces the probability of approving the project. However, by including management options into the project valuation process the value of the project may increase substantially and therefore have an impact on the decision to go ahead or not. We discuss how the application of real options is superior to an NPV approach as it enables the investor to put concrete value on the project uncertainties. The key is flexibility in dealing with the uncertainties by having various options in place that can be exercised as new information emerges. The options derive their value from the fact that they put a floor under possible project losses.We apply the binomial tree method to the valuation of various options associated with high-tech investments, including the option to defer, expand or contract a project. We also consider the value associated with a mixture of equity and debt financing of high-tech, high-risk research projects.