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Introduction
The recognition of risk as an important component in capital budget decision making has long been recognized. The future is uncertain and investment/project appraisal techniques that fail to recognize this fact will almost certainly lead to incorrect conclusions and erroneous recommendations. In a recent paper[l] it was shown how simulation methods will help to identify the possible risks of project failure when using net present value (NPV). What is often not recognized is that NPV, itself, can lead to erroneous conclusions in the face of uncertainty even when the apparent range or distribution of (uncertain) outcomes has been recognized. What is needed is an "adjusted" NPV technique which properly accounts for uncertainty, as experienced in a live environment which this article will attempt to provide. Moreover, recognition of the "correct" NPV approach leads to some surprising, perhaps counterintuitive, results in which apparently unwelcome guests in capital budgeting may turn out to be factors leading to competitive or strategic advantage.
Waiting for an answer
Recent developments in the real options literature (see Dixit and Pindyck[2] for an up-to-date survey and exposition) have suggested a use for financial options pricing theory in the wider context of investment decision making. In particular, if the investment decision is seen in the usual context of maximizing shareholder wealth and is evaluated in terms of NPV calculations, it can be shown that the use of real option techniques enhances the standard NPV methodology in situations where there is an unreconciled dichotomy between ex ante and ex Post information availability. That is, when a significant degree of uncertainty in outcomes for the investment project, such that the passage of time might contribute significantly to the resolution of uncertainty. In other words, when the waiting game might produce substantial benefits.
To illustrate this point consider the following example:
A company is considering investing L1,800 to enhance a new production process that will provide reductions in costs for the foreseeable future. However, the extent of cost reduction is dependent on the level of throughput which, in turn, is dependent on future sales. The marketing manager has suggested two likely scenarios which would give rise to the following cost reductions which would arise at each anniversary of the initial investment:
Scenario I: L300 p.a.