Now you may recall from the third course in our finance specialization, <i>Corporate Financial Decision-Making for Value Creation</i>p, that we highlighted how the most popular methods for evaluating whether a project should be accepted by a company with a discounted cash flow technique, such as net present value analysis, or the internal rate of return method. In this first session together, we're going to describe the problems that may arise when firms attempt to use these techniques without considering the impact of their decision upon managerial flexibility in the face of uncertain future market conditions. Let's demonstrate the initial problem with a quick example. So, let's assume that you're an entrepreneur considering a great new fast food concept, pastizzis, that's right, everybody's favorite Maltese snack food. That delicious pastry commonly filled with ricotta, and for the more adventurous, peas. So, the plan is that you would start out of your own kitchen, and then, a year in the future, you would expand out into a proper food manufacturing facility. So what do the numbers look like? Well, to get things moving in your own kitchen at home, we'll require an initial investment of £50,000. You then forecast the present value of cash flows, assuming that you do go ahead and expand into a full manufacturing process. Specifically, you forecast three possible states of the world. Firstly a 30% chance of generating cash flows net of any additional investment required with the present value of £200,000. A 40% chance of generating £100,000, and a 30% chance of complete failure with a present value of future net cash flows is minus £200,000. So you want to take the standard NPV analysis. We subtract the initial investment required of £50,000 from the present value of expected future cash flows. Which we estimate by multiplying each possible outcome by the likelihood of it occurring and then adding them all together. And we find that the project overall has an NPV of -£10,000 pounds. Now as as a financially savvy pastizzi maker, we would of course walked away from this project. But what if I told you that if you spent the initial £50,000 upfront setting up operations in your own kitchen, that you will then be able to work out what state of the world you would face before expanding into the full sized factory. Now the NPV equation changes markedly. As we would choose not to expand and hence incur the £200,000 loss if we faced the downside state of the market. Now the NPV of the entire deal becomes positive to the tune of £50,000. And its rational to go ahead with the initial investment in the pastizzi manufacturing process in your own kitchen. So whats changed? Well our first calculation which showed negative NPV, answered a very specific question. Question was, what value would be created by commencing operations in our own kitchen? And assuming that we would expand into a commercial operation in one year's time. In contrast the second calculation answered a quite different question. Namely what value would be created by commencing operations in our own kitchen and assuming that we would only expand into commercial operations if the market conditions were not poor. That is the second set of calculations accounted for flexibility in our response to changing conditions. Let's consider another example. A new mineral, Debranium, named after my wife, is discovered at Newport Beach, California. The U.S. Government puts out to tender the right to extract the mineral, and so you conduct an initial analysis. You estimate that the present value of the extraction cost is $100 million, while the present value of the expected revenues is $80 million. Well, what would you bid for the right to extract Debranium? Well, standard NPV analysis is pretty straight forward, right? All we do is deduct the present value of outflows from the present value of inflows. In this case we get a value of negative $20 million. Hold on a second. Does that mean you wouldn't pay $1 for the right but not the obligation to extract Debranium? Of course not. You see, the problem is that this NPV calculation is answering a very specific question. Namely, what is the value created or lost today if we commit to extracting Debranium starting today? Whereas having the right, but not the obligation to extract the mineral, is actually a different proposal all together. Because circumstances might unexpectedly change which may result in this project becoming positive NPV. So what sort of things might change? Well there might be technological advances that significantly reduce the cost of extraction. Or alternatively the manufacturing world might find a new use for Debranium. Which might result in a significant increase in the present value of the expected revenues, once again resulting in the project becoming positive NPV. But the key is that the value is created by having flexibility in how we respond to changes in market conditions. Okay, so that's a different way of looking at things, right? Let me blow your mind a little bit more. Let's say that we're looking at the project forecast and we're now considering variability in the price of Debranium. The risk adverse investor will penalize a project for risk or uncertainty by using a high discount rate when evaluating case flows. But when we're dealing with real options, all of a sudden, as the variability in the price of Debranium increases, this increases the value of the right, but not the obligation, to extract the mineral from Newport Beach. It's quite a different approach, right? In summary, traditional NPV analysis is very good at answering a very specific question, namely, what would be the wealth impact today of going ahead with this investment? Hence, the approach treats projects as "now-or-never" prospects. As a result, it fails to account for the value associated with managerial flexibility and the wealth gained or destroyed when that flexibility is created or removed. Next up, we'll consider different types of real options that are commonly encountered in practice.
