VALUING REAL INVESTMENT OPPORTUNITIES: AN OPTIONS APPROACH TO STRATEGIC CAPITAL BUDGETING (FLEXIBILITY)

Traditional capital budgeting techniques often undervalue investment opportunities due to the presence of managerial operating flexibility and strategic interactions. The main goal of this thesis is to integrate the important operating flexibility options (e.g. to defer or abandon) along with the strategic aspects of competitive interaction and project interdependence (compoundness) in a broad analytical framework.; After reviewing the current state of capital budgeting (Chapter 2) and option pricing (Chapter 3), the thesis proceeds to contribute on three levels: (1) It develops a general conceptual options framework for capital budgeting or an 'Expanded NPV' analysis by viewing real investment opportunities as collections of options on real assets or 'real options' (Chapter 5). (2) It shows how mathematical option pricing can be used to quantify particular aspects of the general framework (Chapter 4), and specifically the impact of competitive interaction (Chapter 6). We find it useful, both in the case of anticipated competitive arrivals that can be preempted by early investment, and in the case of random competitive arrivals (modelled primarily via mixed jump-diffusion processes), to think of the impact of competition as analogous to the effect of 'dividends'. (3) It develops a numerical analysis approach able to extend our valuation ability to complex projects with multiple real options that may interact (Chapter 7). While the 'state of the art' focuses on valuing specific real options in isolation, we show the importance of and interactions between the real options to defer, abandon by defaulting on a pre-planned investment, contract, expand, and switch use (or abandon for 'salvage'). The combined value of these options can be as important as that of expected cash flows so that ignoring all of them may cause substantial undervaluation. On the other hand, possible negative interactions suggest that incremental value of an additional option may be small, and so will valuation errors from ignoring a few particular options. Sensitivity analysis results of the impact of various factors on such options are also presented. The proposed numerical approach provides a far more intuitive framework for analysis than alternative techniques.