It generally includes the opportunity to design the

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Unformatted text preview: , particularly production. It generally includes the opportunity to design the production process to accept multiple inputs, use flexible production technology to create a variety of outputs by reconfiguring the same plant and equipment, and purchase and retain excess capacity in capital-intensive industries subject to wide swings in output demand and long lead time in building new capacity from scratch. Recognition of this option embedded in a capital expenditure should increase the NPV of the project. Growth option The option to develop follow-on projects, expand markets, expand or retool plants, and so on, that would not be possible without implementation of the project that is being evaluated. If a project being considered has the measurable potential to open new doors if successful, then recognition of the cash flows from such opportunities should be included in the initial decision process. Growth opportunities embedded in a project often increase the NPV of the project in which they are embedded. Timing option The option to determine when various actions with respect to a given project are taken. This option recognizes the firm’s opportunity to delay acceptance of a project for one or more periods, to accelerate or slow the process of implementing a project in response to new information, or to shut down a project temporarily in response to changing product market conditions or competition. As in the case of the other types of options, the explicit recognition of timing opportunities can improve the NPV of a project that fails to recognize this option in an investment decision. capital budgeting decision and that explicit recognition of them would probably alter the cash flow and risk of a project and change its NPV. By explicitly recognizing these options when making capital budgeting decisions, managers can make improved, more strategic decisions that consider in advance the economic impact of certain contingent actions on project cash flow and risk. The explicit recognition of real options embedded in capital budgeting projects will cause the project’s strategic NPV to differ from its traditional NPV a...
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