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.
The NPV approach generally supposes that an irreversible investment is made at some point in time and assumes, in its standard form, a constant business risk. It does not consider the timing of the investment as a parameter. In other words, it does not take into account the fact that postponing an investment provides an opportunity to learn more about the uncertainty of some of the project variables.
A company with an investment project is a company holding a “call option”, a right (but not an obligation) to invest in an asset at some point in the future. When the decision to invest is taken, the option is “killed” and the company gives up on the possibility of learning more about the uncertainties surrounding the project. This lost option value is an opportunity cost that is not captured by “standard” NPV, but which should be taken into account when making an investment analysis.
Scholars have shown that the “standard” NPV approach is inappropriate when the following conditions are present:
- The “standard” NPV of the project is close to zero or is negative;
- There is a high uncertainty on some of the key value drivers of the projects and the NPV is sensitive to these value drivers;
- Management can react on the resolution of the uncertainties (switch from one production process to another, delay investments, reduce capacity, increase capacity, etc).
When these three conditions are met a Real Option valuation approach is recommended as it will fully capture the optional characteristics of an investment and should lead to a better decision taking process.
The above conditions are usually present in companies investing heavily in R&D (pharmaceutical companies, biotechnology companies), in start-ups (seed capital Venture Capitalists), in natural reserves (oil companies), etc. Today however, in an environment that is changing at an ever-faster speed, these conditions are also beginning to be met in numerous other sectors.
[to be continued – Part II ]
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