This article tries to explain why
managers should use real options when planning a project rather than using the
discounted cash flow (DCF). The author explains that with the discounted cash
flow, the decision making process is more like a “do-it-now-or-never
proposition. Which means “traditional capital budgeting approaches assume that
managers undertake ‘discrete’ investments rather than investments unravel in
stages”, (55 Strategic Finance). With real options, the article defines it as
an “alternative approach to capital investments by taking into account that
companies can postpone a business decision, either to continue or abandon
projects, based on how future uncertainty unfolds”, (55 Strategic Finance).
What seems to be the most important factor in real options is that this
approach helps managers identify the stages of the projects what needs more or
less investment due to any new information that is received. The real options
are more flexible and instead of having volatility be seen as having a negative
impact, it is taken more of a positive outlook to the project.
The article using the movie industry as
real options research, stating the studios use this approach when figuring out
how much to the movie budget should be, and how much marketing and advertising
funds should be used. Two different options are usually used during the
project, the growth option and the abandonment option. The growth option is
defined in the article as “the right to make additional investments if the
initial investment is successful”, (56 Strategic Finance). In the movie
industry this usually means there will be sequel if the original is a success.
With the abandonment option, the budget for advertising is taking into effect,
which will affect the promotion of the movie after the opening night, or even
scrapping the promoting all together and release the movie straight to video.
With various techniques, a studio can
see if a movie will be a flop or a success during production and after the release
of the movie. However, sometimes a studio may be planning the sequel even when
the original is still being produced, which means the studio has the grown
option in mind while starting the original movie., thus making the project more
flexible with change.
The
article claims the flexibility with real options is the key here. With real
options mangers, outside the movie industry, will be more equipment to deal
with changes in its environment, thus giving managers a advantage their market
as well as a instrument to use in their corporate finance. According to this
article only 10 to 15 percent of the Fortune 1,000 companies use the real
option approach, (59 Strategic Finance). The articles main objective is to
point out that the strategic investments that the movie industry uses, can be
applied to the capital investment decision used the multiple markets, like
cable, pharmaceutical, paper, and even construction industries and be
successful in planning and growing projects.
Source:
Strategic
Finance;
May2012, Vol. 93 Issue 11, p53-59, 6p, 2 Diagrams, 2 Charts
Rachael
ReplyDeleteThank you for your article on real options.I find it surprising that only 10-15% of Fortune 1000 use this approach considering most financial investors use it to predict future options. Maybe more companies will start using the real option approach after seeing the successes of the fellow competitors.
Rachael,
ReplyDeleteThanks for a topic involving movies, they are always interesting to read. I too am surprised that so few fortune 1000 companies are utilizing real options. I would have thought that it would be better than the abondoment option for at least some endeavors.
The real options approach to making investment decisions under uncertainty is a highly useful framework, especially when projects warrant multiple stages of investments. Though real options provide a company with flexibility to adapt to changes in its environment, we also suggest that it's a tool managers can use to navigate corporate finance and competitive strategy. Surveys conducted by other researchers show that only about 10% to 15% of Fortune 1,000 companies use the real options approach, and their degree of usage varies. This may be the result of the lack of clear examples.
ReplyDeleteThe articles presents very practical advantages of using real options and reasons for companies to consider real option compared to discounted cash flow. The idea of more flexibility with real options seems to provide vital benefits. I feel that the ability to identify the stages of the project and adjusting investments due to new information and the leeway to postpone a business decision due future uncertainty is high valuable for planning a project. Thus, as the article suggests the real options approach seems to be a better option for some industries such as the movie industry.
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