The Theory ＆ Method Of Real Options In Investment Decision Of Venture Capital

In the knowledge-economy age, high-tech has been the main factor of productivity and the competition of integrated national power represented by high-tech is increasingly drastic. Thus, as the brooder of high-tech, venture capital becomes more and more important. In comparison with developed countries, venture capital in China is still in the primary stage. While many scholars have studied the theories on its macro-operating mechanism, few researchers have done work on its appraisal method. The lagging of appraisal method has delayed the development of China’s venture capital. Therefore it is of great significance to construct a newly effective investment appraisal system of venture capital project for promoting the development of high-tech and national economy.Traditional investment appraisal method, representing by cash flow discounted technique, has many drawbacks in valuing venture capital investment. Firstly, misunderstanding of uncertainty. Uncertainty includes both risk and opportunity, but traditional investing appraisal theory believes that the higher uncertainty implies the more lost by treating opportunity as risk, which ignore that the distinct characteristic of venture capital is the uncertainty of return and cost. It would lead to the neglect of the value of investment opportunity, managerial flexibility and the time to investment in venture capital. Secondly, there is wrong assumption of investors. The traditional valuing method assumes that the behaviors of investors are rigid and passive, namely, investors must make a decision of either investing immediately until the end of the project or giving up it forever. In fact, the investors could be active. They can adapt the original plans with the change of investment environment. This is the dynamic flexible management. So traditional investment appraisal method will underestimate the value of venture capital, and the venture capital will be insufficient.Myers (1977) applied option theory to real asset appraisal firstly and named it as real option, which brought out a new idea for the lagging investment appraisal method. Since option has the right to implement an activity, but has no obligation of implementing this activity, the venture capital decision based on option theory can not only control the risk, but also obtain the latent opportunity. Real option theory and method is a new decision thought and evaluating model, it has important theoretic and practical values for venture capital investment. The Main Contents and Conclusions:This dissertation divides eight chapters, the major research including:1. The dissertation summarizes traditional appraisal methods of venture capital, shows their drawbacks in valuing venture capital investment based on properties of venture capital such as high profit with high risks, indicates that they neglect the flexible value and waiting value in venture capital investment, and hence they underestimate the value of investment. Since their assumptions are not absolutely suitable for the appraisal of venture capital project, the conception and method of new financial management representing by real option theory has good reference for the study of this dissertation.2. The dissertation studies the styles, properties and application scope of real options deeply. Through comparison of finance option with real option, the major difference is figured out that real option is compound, and is not exchangeable and proprietary. Then the dissertation discusses the key issues on the application of real option method, and illustrates the appraisal mechanism of real option. Using two kinds of pricing method, continuous-time pricing method and diffusion-time pricing method, it estimates the value of real option, compares the two pricing method and discusses their advantages and disadvantages respectively.3. Based on risk theory in venture capital, the dissertation compares uncertainty with risk, analyzes the misunderstanding of uncertainty in traditional theory, and discusses the influence of uncertainty decision on the progress of economics. Then it indicates it is more suitable for applying real option method to the investment appraisal of venture capital than traditional appraisal methods.4. The dissertation proves that venture capital investment has properties of real option theoretically. Based on the division of operating stages of venture capital investment, it indicates that venture capital investment is a process of sequential investment. Current investment does not aim at the sale of product and service at once, but is a beginning of many investment stages in order to get the chance of high profit in the future. The venture capital project has the properties of option to abandon or postpone. Even the investment has begun, investor can give up or defer the project if only continuing investment is not appropriate. The property of sequential investment of venture capital gives the project not only management flexible, but also the value of option.5. The dissertation introduces real option theory and method into the investment appraisal of venture capital. On the basis of the property of sequential investment and risk factor in venture capital, a real option model is built. The model simultaneously describes four properties of venture capital project: (1) multi-stages of venture capital investment process; (2) value uncertainty; (3) cost uncertainty; (4) the jump of project value resulted from unpredictable catastrophic events.6. The dissertation discusses the effect of regime-shift in venture capital investment. It reviews the studies of government policy effects on the venture capital projects in the past, and indicates that proper policy could promote the success and development of the investment project greatly. Based on the real option appraisal model of venture capital project, introducing regime-shift factor, the dissertation designs a real option model under regime-shift and gives the main parameters analysis.7. The dissertation studies the decision and valuing of shared investment chance. One venture capital investment chance is always possessed by different investors. Combining option theory with game theory to study venture capital investment is an available way. Based on the real option appraisal model of venture capital investment above, introducing demand function, the author develops an option game model to value venture capital projects when there are two competitors and gives the main parameters analysis compared with monopoly.In conclusion, the dissertation deeply studies the value, policy effects and competition of venture capital investment using real option methods based on traditional investment appraisal theory. It builds an effective investment appraisal system that provides a new thought for valuing venture capital project.The Major Contribution of the Dissertation:1. The dissertation reviews the studies of traditional investment appraisal theory, analyzes the main contents and restrictive conditions of them, and indicates their drawbacks in valuing venture capital investment because of neglecting the management flexibility. As a result, it urgently needs a new method in appraisal project.2. Based on risk theory in venture capital, the dissertation clarifies the difference between uncertain and risk, studies the application scope and valuing mechanism of real options deeply and proves the real option property of venture capital.3. The dissertation studies the uncertainty of project cost and value in detail, and then develops a real option model with jump process according to properties of venture capital such as high profit with high risks and many stages of capital investment.4. The dissertation designs a real option model under regime-shift to discuss the effect of policy uncertainty on venture capital investment. The main results from the numerical analysis are summarized. As investment conditions become more variable, the investor that is expecting a favorable regime change in the near future reduces investment more now; on the contrary, the investor would invest more readily when it is expected that the unfavorable regime change will occur soon.5. The dissertation studies the venture capital decision with competition, and develops an option game model to value venture capital projects when there are two competitors. Implementation of the model shows that the value of the venture capital project in the monopoly situation is higher than the sum of the values of the two projects in the duopoly situation because of competitive interactions. And at the same time, the competition in venture capital increases not only the total production but also the probability of a successful development because catastrophic events are diversified over the two duopolists.6. The dissertation attempts to build a venture capital investment’s appraisal system based on one primarily valuing model, which helps to complement venture capital appraisal and provides a new idea for valuing venture capital project.