Transactions Blog

When confronted with a situation where the “standard” NPV is inappropriate (see article – Part I), one should first identify all the value drivers and the key elements of the business plan for which uncertainty is high. It should then identify all the options for which it has either to mitigate these uncertainties or to react upon their resolution: the option to postpone the investment, to downsize production capacity, to close down capacity, to exit, to increase capacity, to transform itself into another business, etc.

The difficulty in this process is to find the relevant options, the ones bringing value to the project – the ones for which undertaking a real option valuation approach will be worthwhile.

The fact that management can stop a research project whenever the results of a test are negative, that uncertainty about the success of a research programme is high and that the NPV of such a programme is close to zero clearly indicates that a real option valuation approach should be used. The three conditions discussed in the previous article are met. Starting research on a chemical formula today is effectively an option that gives the right to make pre-clinical trials in a few years. These pre-clinical trials are nothing else but a further option giving the right, if they are successful, to make clinical trials. The clinical trials in turn provide yet another option to invest in a production process if they turn out to be positive. Today, valuing research programmes as a portfolio of compounded options is the best way to estimate the real value of an R&D programme.

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How should a firm and its management evidence its decision to invest in a company, in new equipment, in new projects, in new markets? Most of us have learned at some point in our education that such a decision should be based on financial analysis, looking at the payback period, at the internal rate of return or better, at the Net Present Value of the project. We have been taught that we should invest if the Net Present Value (NPV) of the project is positive. Yet many readers will agree with me that in “real life”, projects with a “high” internal rate of return happen to be postponed and that for “strategic reasons”, projects happen to be undertaken when their NPV is negative. And, after all, sometimes these decisions appear to have been the good ones…

So, are the decision tools we were provided with the right ones? Are we missing something? Should we forget NPV to assess our investments and rely on “strategy”, “vision” and “business flair” only?

No ! Tools such as NPV were developed at a time when technology and market developments were evolving at a slower pace than at the beginning of the 21st century, at a time when uncertainties about future prices, sales volumes and regulations were lower than today. These tools have been useful and remain useful in many situations. In some circumstances, however, their use can lead to inappropriate decisions. The key issue for management is to identify when this might happen and in these cases to use better, more appropriate tools.

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