The failure to recognize the value of real options

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Unformatted text preview: cceptable (NPVstrategic $0). The failure to recognize the value of real options could therefore cause management to reject projects that are acceptable. Although doing so requires more strategic thinking and analysis, it is important for the financial manager to identify and incorporate real options in the NPV process. The procedures for doing this efficiently are emerging, and the use of the strategic NPV that incorporates real options is expected to become more commonplace in the future. Capital Rationing Hint Because everyone in the firm knows that long-term funds are rationed and they want a portion of them, there is intense competition for those funds. This competition increases the need for the firm to be objective and proficient in its analysis. Knowing how to use the techniques discussed in this chapter to justify your needs will help you get your share of the available long-term funds. Firms commonly operate under capital rationing—they have more acceptable independent projects than they can fund. In theory, capital rationing should not exist. Firms should accept all projects that have positive NPVs (or IRRs > the cost of capital). However, in practice, most firms operate under capital rationing. Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management. Research has found that management internally imposes capital expenditure constraints to avoid what it deems to be “excessive” levels of new financing, particularly debt. Although failing to fund all acceptable independent projects is theoretically inconsistent with the goal of maximizing owner wealth, here we will discuss capital rationing procedures because they are widely used in practice. 448 PART 3 Long-Term Investment Decisions internal rate of return approach An approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects. investment opportunities schedule (IOS) The graph that plots project IRRs in descending orde...
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