Measures of correlation

Figure 13-9 Levels of risk reduction as measured by the coefficient of correlation

Table 13-8 Rates of return for Conglomerate Inc. and two merger candidates

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Real Options Add a New Dimension to Capital Budgeting Finance in ACTION Managerial

According to traditional net present value analysis, the expected yearly inflows are discounted back to the present at the cost of capital, and their present value is compared to the cost of the investment. If the present value of the inflows is larger than the investment, the investment is considered acceptable; if not, it is rejected.

But some would argue this process is incomplete because it fails to consider the flexibility to revise decisions after a project has begun. For example, assume an oil company decides to drill for oil in 10 adjacent sites over the next five years. Under traditional capital budgeting analysis, the present value of expected cash flows would be discounted back for five years and compared to the cost of the venture. But traditional capital budgeting does not consider the intermittent decisions that can be made during the life of the project.

Let’s initially assume that the oil drilling project has a negative net present value. But in further analyzing the project, we include the option that if after hitting two successful oil wells, we encounter three dry holes, we will abandon the project and cut the size of our investment. This could lead to a positive net present value, especially if the last five drilling attempts were going to be particularly expensive.

Alternatively, let’s assume that if the first two sites turn out to be much more productive than initially anticipated, we expand the project to 15 sites by including other nearby potential oil wells. We might also have two or three other options. By including these options in the initial planning, a negative net value project may take on a positive return.

The options discussed here are termed real options because they involve assets as opposed to financial options, which relate to stocks and bonds.

Real options might include the flexibility of terminating a project, taking a more desirable route once initial results are in, greatly expanding the project if there is unexpected success, and so on. Such elements are particularly likely to be present in natural resource discovery, technology-related investments, and new product introductions. But the list does not stop there. Almost every capital budgeting project contains a potential element of flexibility once it’s put into place. There is a real option to change the course of action, and this real option has a monetary value just as a financial option does.

The value of the real option is the difference in the net present value of the project with the flexibility included in the analysis versus the traditional static net present value analysis. An analogy can be drawn to playing poker where you can return part of your hand and draw again in five-card draw, versus five-card stud in which you must stay with the cards that are initially dealt to you.

Including real options in a capital budgeting analysis sounds good, but the process is not widely used. A recent study showed that only 14.3 percent of the Fortune 1000 companies use real options in any form in their analysis.7 The primary reasons for this low utilization are lack of sophistication and distrust that the options will actually be properly used in the future. This low utilization rate is likely to change in the future as sophistication increases.

7Stanley Block, “Are ‘Real Options’ Actually Used in the Real World?” The Engineering Economist 52, no. 3 (2007), pp. 255–267.

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Since management desires to reduce risk (σ) and to increase returns at the same time, it decides to analyze the results of each combination.8 These are shown in the last two columns in Table 13-8. A combination with Positive Correlation Inc. increases the mean return for Conglomerate Inc. to 13 percent (average of 12 percent and 14 percent) but maintains the same standard deviation of returns (no risk reduction) because the coefficient of correlation is +1.0 and no diversification benefits are achieved. The +1.0 value is shown on the bottom line in black. A combination with Negative Correlation Inc. also increases the mean return to 13 percent, but it reduces the standard deviation of returns to 0.63 percent, a significant reduction in risk. This occurs because of the offsetting relationship of returns between the two companies, as evidenced by the coefficient of correlation of −.9 (bottom line of Table 13-8 in black). When one company has high returns, the other has low returns, and vice versa. Thus a merger with Negative Correlation Inc. appears to be the best decision.