Capital Investment Appraisal Essay Example | Topics and Well Written Essays - 750 words

Capital Investment Appraisal - Essay ExampleIn applied not bad(p) budgeting, however, the fundamental concept of managerial flexibility, or active project management, has been well accepted and long practiced. In the past, superstar way decision-makers have attempted to supplement a traditional analysis is with what if analyses, such as sensitivity analyses, scenario analyses, and simulation. However, richer and more efficient uppercase budgeting decision-making frameworks ar needed and they should directly translate into increased corporal effectiveness, profitability, and long-term survival in todays globally competitive marketplace. (Black 637-354)The primary enhanced decision-making framework is a legitimate option analysis. During the last fifteen years, increasing attention has been given to the real option approach to capital investment decision-making. Real options ... allow managers to add value to their firm, by acting to amplify good portion or to mitigate loss. Whe n real options are present, the traditional DCF methodology may fail to declare oneself an adequate decision-making framework because it does not properly value managements ability to wait, to revise the initial operating outline if future events turn out to be different from originally predicted, or to account for future (dis)investment. (Trigeorgis 202-224 Fabozzi 7-9 Grinblatt 9-15) Thus, figure the value of the decision rights of managers to actively manage investment opportunities is not simply a matter of droping. In addition, since management is not committed to revising the firms investment strategy or undertaking these future arbitrary opportunities, the right to do so is truly an option. That is, managers undertake these opportunities only if and when they chose to do so. In practice, capital investments are determined by managerial discretion where the available options to invest in real assets is evaluated on an on-going origination and each exercised, deferred, o r allowed to expire. An option-based approach is, therefore, an excellent representation of the managerial decision-making process. To be simple the internal capabilities of a firm must be matched to its external opportunities in order for managers to maximize shareholders wealth. The real options are characterized by the flexibility they offer in timing of decisions involving the capabilities and opportunities of the firm (Walters and Giles 1-7 Ross 96-102 Chung 1215-1221 Copeland 15-22). The true NPV of a project can be viewed as the sum of the traditional NPV and the values of inherent real optionsTrue NPV = Traditional NPV + NPV of Real Options.To crystalize the value of options from active management, suppose that a firm considers producing a new product, which requires an initial outlay of $1 million. The capacity of the production facility over one expiration would be 40,000 units. The variable cost of producing one unit of this product is $390. The price of the product in one period from now would be either $300 or $500 with an estimated probability of 50 percent for each state of the nature. The appropriate discount rate for the project is 15 percent. The expected cash flow from the project after one period woul