Capital Budgeting With Strategic Options

Traditional capital budgeting

Analyzing long-term investments in advance of accepting or rejecting the idea is commonly known as capital budgeting. Traditional approaches have been divided into those which ignore the time value of money and those which accommodate it. Payback period and the benefit-cost ratio are two methodologies that continue to have some merit. Payback period represents the time required for a newly adopted project to realize positive cash flows from a project just adequate to cover its initial cost. The benefit cost ratio gives the ratio of positive cash flows generated by a project divided by its original cost. Each of these parameters is easy to calculate, easy to understand, gives certain insights and consequently remains useful. The methodologies that take the time value of money into consideration are generally regarded as superior. The primary techniques included here are net present value, internal rate of return, and profitability index. Net present value adjusts future cash flows to a present worth by discounting them using an interest rate commonly set equal to a firm's cost of capital. From this discounted resent worth, the initial cost is subtracted to estimate the net present value of a project. Those projects with positive net present value are deemed acceptable, and those with negative net present value are deemed unacceptable. The internal rate of return technique finds an interest rate that equates the present worth of future cash flows with the project's initial cost. This rate, the internal rate of return, is compared to the firm's cost of capital. Projects generating an internal rate of return exceeding the firm's cost of capital are deemed acceptable and those generating internal rates of return below the firm's cost of capital are rejected. The profitability index is calculated by dividing the present worth of future cash flows generated by a project by its original cost. Profitability indices greater than 1 indicate that a project should be adopted and those below 1 indicate that a project should be rejected. Given consistency in their approach, all three of these techniques should generate identical results regarding the desirability of projects. Generally, however, the net present value approach is preferred. It gives a value logically consistent with the change in worth of an organization when the project is adopted. Conversely, internal rate of return carries the potential for confusion when some cash flows are not completely internal to the project. For example, when net cash outflows follow at least some of the net cash inflows. From Descartes rule of signs we know that polynomials with more than one sign change in its coefficients can have more than one real root. Thus, unique internal rates of return may not exist on projects having interspersed net cash outflows and inflows.
A major criticism of traditional capital budgeting is its static nature. Projects are essentially analyzed according to an initially assumed operating strategy. Presumably, at the origination of the idea, this operating strategy is the best available. However, over time new alternatives may become apparent or previously unattractive alternatives may become attractive. It is desirable to be able to incorporate such alternatives into the capital budgeting analysis. Various extensions and modifications of the traditional capital budgeting techniques have been developed. Our purpose here is to move along to incorporating strategic options into capital budgeting. Thus, other extensions and modifications will be ignored.

Strategic options

As new information arrives over a project's lifetime, it may become apparent that the initially adopted operating strategy needs adjustment. Most, if not all, organizations would make such adjustments when circumstances indicate superior alternatives are available. Adjustments might include deferring adoption of a project or its completion, expanding the project's size, contracting the project's size, abandoning the project, or altering the technology or characteristics of the project in some way. Management's ability to accomplish these various adjustments constitute its strategic options regarding a project. Option theory is well developed for the purpose of estimating the initial worth of an option that offers later rewards. The initial worth is typically estimated in the form of a premium. Depending on the characteristics of information available in advance, several alternate methodologies exist for estimating such premiums. The premium worth can effectively be added to the net present value calculated for a project to get an enhanced assessment of the project's true worth. Thus, the option adjusted worth of a project better reflects its value to a firm than does the static net present value technique.