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Unformatted text preview: over project Y. Given that projects X and Y are
mutually exclusive, project X would be the recommended project
because it provides the higher annualized net present value. Recognizing Real Options real options
Opportunities that are embedded
in capital projects that enable
managers to alter their cash
flows and risk in a way that
affects project acceptability
(NPV). Also called strategic
options. The procedures described in Chapters 8 and 9 and thus far in this chapter suggest
that to make capital budgeting decisions, we must (1) estimate relevant cash
flows, (2) apply an appropriate decision technique such as NPV or IRR to those
cash flows, and (3) recognize and adjust the decision technique for project risk.
Although this traditional procedure is believed to yield good decisions, a more
strategic approach to these decisions has emerged in recent years. This more
modern view considers any real options—opportunities that are embedded in
capital projects (“real,” rather than financial, asset investments) that enable
managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Because these opportunities are more likely to exist in, and be
more important to, large “strategic” capital budgeting projects, they are sometimes called strategic options.
Some of the more common types of real options—abandonment, flexibility,
growth, and timing—are briefly described in Table 10.4. It should be clear from
their descriptions that each of these types of options could be embedded in a 446 PART 3 Long-Term Investment Decisions TABLE 10.4 Major Types of Real Options Option type Description Abandonment option The option to abandon or terminate a project prior to the end of
its planned life. This option allows management to avoid or minimize losses on projects that turn bad. Explicitly recognizing the
abandonment option when evaluating a project often increases
its NPV. Flexibility option The option to incorporate flexibility into the firm’s operations...
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This document was uploaded on 01/19/2014.
- Fall '13