European Journal of Economics, Finance and Administrative Sciences ISSN 1450-2275 Issue 45 (2012) EuroJournals, Inc. 2012 http://www.eurojournals.com/EJEFAS.

htm

A Fuzzy Real Option Valuation Approach to Capital Budgeting under Uncertainty

Gholamhossien Nikookar Faculty Member of Emam Hossien University Seyed Ali Azarmsa Student of MBA at Tehran University Farzam Pooramazan Student of MBA at Tehran University Ali Shahvazian Student of MBA at Tehran University Abstract The information needed for capital budgeting is generally not known with certainty. Therefore, capital budgeting procedures under conditions of uncertainty should be developed to improve the precision of assessment of the value of risky investment projects. The sources of uncertainty may be either the net cash inflow, the life of the project, or the discount rate. We propose a capital budgeting model under uncertainty in which cash flow information can be specified as a special type of fuzzy numbers. Then, we can estimate the present worth of each fuzzy project cash flow. At the same time, to select fuzzy projects under limited capital budget, we give an example to compare and analyze the results of the capital budgeting problem using a fuzzy real option model. Hence, the fuzzy numbers and the real option model can be jointly used in solving capital budgeting under uncertainty.

Keywords: Capital budgeting; Real option; Fuzzy numbers; Uncertainty.

1. Introduction
Large investments are capital projects of strategic importance which have a long economic life cycle. They often have many unknown that hard to estimate risks and potentials, difficult to be foreseen at their initial planning stage. Hence these investments may change during their long economic life and the changes can be fundamental. Such uncertainty and possibility of change in the fundamentals of large investments which is essential, because of the larger the investments are, the more strategic importance they usually have. However, the information needed for capital budgeting is generally not known with certainty. Therefore, capital-budgeting procedures under conditions of uncertainty should be developed to improve the precision of assessment of the value of risky investment projects. The sources of uncertainty may be either the net cash inflow, the life of the project, or the discount rate. In practice precise information concerning future investment projects is rarely obtained. Extensive study has been undertaken to consider the capital budgeting problems under risk. Hence decision maker does not have exact knowledge concerning future investment opportunities. Traditional approaches to capital budgeting are based on the premise that probability theory is necessary and

87

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

sufficient to deal with the uncertainty that underlie the estimates of required parameters. It is argued that, in many circumstances, this premise is invalid since the principal sources of uncertainty are often non-random in nature and relate to the fuzziness rather than the frequency of data. In order to capture and quantify correctly the underlying uncertainty present in non-statistical situations, the theory of possibility, an extension of the theory of fuzzy sets introduced by Zadeh (1965). A possibility distribution can be viewed as the membership function of a parameter. In the real world, the data sometimes cannot be recorded or collected precisely. For instance, if considering to ask a group of economists for predicting the rate of economical growth in the next year. Their statements may be like approximately 3%, should be 35% or may be below 6%, etc. All of those statements can be characterized as fuzzy sets. Suppose that we introduce a selection procedure which will determine the probability that each economist will be selected. Then for each possible selection, their statements are fuzzy sets. Therefore, to deal with a capital budgeting model under uncertainty, the cash flow information can be specified as a special type of fuzzy number-triangular fuzzy numbers. Zadeh (1965), Dubois and Prade (1988), and Carlsson and Fuller (2002) have investigated the usefulness of the fuzzy set theory in decision making under uncertainty. The fuzzy capital budgeting approaches allow cash flow estimates as fuzzy numbers and offer the means to integrate trend data into cash flows. Fuzzy cash flows can better reflect the uncertainty in the project. In this paper, fuzzy capital budgeting is to use fuzzy versions of the neo-classical capital budgeting methods and real option valuation. In Section 2, we will discuss methods for capital budgeting and investment decision making. Next section derives the fuzzy real option method. Section 4 gives a numerical example to compare and analyze the results of the capital budgeting problem using a fuzzy real option model and conclusion in section 5.

2. Methods for Capital Budgeting and Investment Decision Making

Capital budgeting methods based on the discounted cash flow (DCF) have been the ruling instruments for investment decision making. The most commonly used DCF based method is the net present value (NPV). Under static circumstances and in truly now or never situations, DCF based methods provide reliable results, but the real world situations are seldom static. Especially in cases of large investments with long economic lives the static discounted cash flow based methods fail to present a highly reliable picture of the profitability and possibilities offered by the investment project at hand. As DCF based methods have been the best thing available, and it is better to use them than not to use any kind of decision tool for capital budgeting, they have rooted to management practices during years of use. However, there are many enhancements to the original formulae, but the underlying unsatisfactory assumptions still exist. Hence the adjustment models include the risk-adjusted discountrate methods, and the certainty-equivalent method. The risk-adjusted discount-rate method simply extends the cash-flow valuation model under certainty to the uncertainty case. The advantage of this method is that the valuation model gives us a formula that explicitly considers the uncertainty associated with future cash flows. Although the model does not specify exactly what constitutes the risk of the cash flows, it can be used to develop and explore the relationships among the variables of asset-valuation models. On the other hand, the disadvantages of the risk-adjusted discount-rate model are clear. The value of interest rate is only a subjective estimate, which could well differ from person to person. Therefore, an objective determination of the value of a risky investment project will be almost impossible by simply applying this method. While the risk-adjusted discount-rate method provides a means for adjusting the basic riskless discount rate, an alternative method, the certainty-equivalent method, adjusts the estimated value of the uncertain cash flows. The underlying rationale is that, given a risky cash flow, the decision maker will evaluate this risky cash flow by attaching an expected utility to that cash flow, that utility estimate being hypothesized to be equal to the utility derived from some certain amount. If the decision maker performs this process for each cash flow, a series of certainty equivalents for the risky flows can be obtained. Above both methods are used to evaluate future

88

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

uncertain cash flows, the two models should yield the same value for a given stream of cash flows. Moreover, the present value of each period's cash flows should be the same under these two valuation models. Robichek and Myers (1966) showed that the risk-adjusted rate method tends to lump together the pure rate of interest, a risk premium, and time (through the compounding process), while the certainty-equivalent approach keeps risk and the pure rate of interest separate. This separation gives an advantage to the certainty-equivalent method. To remedy the problems of the DCF based methods new methods have been introduced. The real option approach is a methodology that calculates the value of an investment with techniques originally developed for valuation of financial options. This gives the possibility to take into consideration the managerial flexibility to take action during the lifetime of an investment. The term real option was coined in an article about corporate borrowing by Myers (1997). Since then there has been a growing literature describing the different theoretical aspects of real options (Kulatilaka and Marcus, 1998; Dixit and Pindyck, 1994; Trigeorgis, 1995), as well as the managerial and strategic implications and application of real options (Bowman and Hurry, 1993; Luehrman, 1998; Amram and Kulatilaka, 1999). A number of case based articles are also available to give further insight into real world application (Kulatilaka, 1993; Nichols, 1994; Micalizzi, 1999). The value of a real option is computed by using the Black and Scholes (1973) formula extended by Merton (1973). Some Economic factors, such as competition, consumer preferences, technological development, and labor market conditions are a few of the factors that make it virtually impossible to foretell the future. Consequently, the economic life, revenues, and costs of investment projects are less than certain. With the discuss of risk, a firm is no longer indifferent between two investment proposals having rates of return equal or net present values. Both net present value and its standard deviation should be estimated in performing capital-budgeting analyses under uncertainty. There are three related stochastic methods useful in the making of capital-budgeting decisions which are the probabilitydistribution, decision-tree, and simulation methods. The statistical distribution method which Chen and Moore (1982) have generalized this model by introducing the estimation risk. Hillier (1963) combines the assumption of mutual independence and perfect correlation in developing a model to deal with mixed situations. This model can be used to analyze investment proposals in which some of the expected cash flows are closely related, and others are fairly independent. A decision-tree approach to capital-budgeting decisions can be used to analyze some investment opportunities involving a sequence of investment decisions over time. It is an analytical technique used in sequential decisions, where various decision points are studied in relation to subsequent chance events. This technique enables one to choose among alternatives in an objective and consistent manner. Simulation is another approach to confronting the problems of capital budgeting under uncertainty. Because uncertainty associated with capital budgeting is not restricted to one or two variables, every variable relevant in the capitalbudgeting decision can be viewed as a random variable. Facing so many random variables, it may be impossible to obtain tractable results from an economic model. Simulation is a useful tool designed to deal with this problem, and is the closest we can get to modeling in cases of uncertainty. Generally speaking, the probability-distribution, decision-tree, and simulation methods are three alternative approaches that are available to deal with the problem of capital budgeting under uncertainty. These methods have explicitly utilized the concepts of probability distributions and statistical distributions to carry out the analysis. If there is only a single accept-reject decision at the outset of the project, then the decision maker can use either statistical-distribution methods or simulation methods. If investment opportunities involve a sequence of decisions over time, then a decision-tree method can be used to perform the analysis. In addition, if want to reduce risk of the investment, the real option is a better choice. The real option approach also supports the determination of the timing for the investment, and offers a comprehensive way of presenting value of possibilities opened by the project, which is further enhanced with frequently updated fuzzy cash flows.

89

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

3. The Fuzzy Real Option Valuation (FROV) Approach

3.1. Fuzzy Numbers From Zadeh (1965), A is a convex fuzzy set if and only if its -level set A = {x : A ( x) } is a convex set for all any . Therefore, if is a fuzzy number, then the -level set is a compact (closed and bounded in R) and convex set; that is, is a closed interval. The -level set of is then denoted L by = [ , U ] . A fuzzy number is said to be nonnegative if ( x) = 0 for x<0. It is easy to see that if L is a nonnegative fuzzy numbers then and U are all nonnegative real numbers for all [0,1] . 3.2. Triangular Fuzzy Number, TFN The concept of triangular fuzzy number attempts to deal with real problems by possibility. The membership of a triangular fuzzy number is defined as follows:
A ( x) = (U x) / (U M ) L x M
0 otherwise ( x L) / ( M L) M x U

Figure 1: The Membership Function of the Triangular Fuzzy Number

A (x)
1

According to the characteristics of triangular fuzzy numbers and the extension principle put forward by Zadeh (1965), the operational laws of triangular fuzzy numbers, A = (l1 , m1 , r1 ) and B = (l2 , m2 , r2 ) are as follows: (1) Addition of two fuzzy numbers
(l1 , m1 , r1 ) (l2 , m2 , r2 ) = (l1 + l2 , m1 + m2 , r1 + r2 )

(2) Subtraction of two fuzzy numbers

(l1 , m1 , r1 )(l2 , m2 , r2 ) = (l1 r2 , m1 m2 , r1 l2 )

(3) Multiplication of two fuzzy numbers

(l1 , m1 , r1 ) (l2 , m2 , r2 ) (l1l2 , m1m2 , r1r2 )

(4) Multiplication of any real number k and a fuzzy number

k (l1 , m1 , r1 ) = (kl1 , km1 , kr1 )

(5) Division of two fuzzy numbers

(l1 , m1 , r1 )(l2 , m2 , r2 ) (l1 / r2 , m1 / m2 , r1 / l2 )

3.3. A Real Option Valuation A real option means that the possibility for a certain period to either choose for or against making an investment decision, without binding oneself up front. The real option rule is that one should invest today only if the net present value is high enough to compensate for giving up the value of the option to wait. Because the option to invest loses its value when the investment is irreversibly made, this loss is an opportunity cost of investing. While ongoing evaluation effort is structured around key decision points, or triggered by changes in the business environment, it is a process in which the valuation, even the computing process, is not intended to provide a definite answer, but rather to provide decision

90

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

makers an ongoing dialogue about the project (Dahiberg and Porter, 2000). So a process view of the real option approach is a relevant task in analyzing the decision support needs. Real options in option thinking are based on the Black-Scholes model as financial options. The option pricing theory is that you should invest today only if the net present value is high enough to compensate for giving up the value of the option to wait. Because the option to invest loses its value when the investment is irreversibly made, this loss is an opportunity cost of investing. Following Leslie and Michaels (1997), we will compute the value of a real option as
ROV = S 0 e T N (d1 ) Xe rT N (d 2 ),

where
d1 = ln( S0 / X ) + (r + 2 / 2)T

, d 2 = d1 T

and where ROV denotes the current real option value, S0 is the present value of expected cash flows, X is the (nominal) value of fixed costs, quantifies the uncertainty of expected cash flows, and denotes the value lost over the duration of the option. In real options, the options involve real assets. To have a real option means to have the possibility for a certain period to either choose for or against making an investment decision. Real options can be valued using the analogue option theories that have been developed for financial options, but do not mean that they are the same. Real options are concerned about strategic decisions of a company, where degrees of freedom are limited to the capabilities of the company. In these strategic decisions different stakeholders play a role, especially if the resources needed for an investment are significant and thereby the continuity of the company is at stake. In addition, it is quite different from traditional discounted cash flow investment approaches. The traditional methods are very hard to make a decision when there is uncertainty about the exact outcome of the investment. And since these methods ignore the value of flexibility and discount heavily for external uncertainty involved, many interesting and innovative activities and projects are cancelled because of the uncertainties. If the result of NPV is negative, the company would obviously pass up the opportunity. But if we use the real option valuation the result may be different of the same case. Such a valuation would recognize the importance of uncertainty, which the NPV analysis effectively assumes away. The main question that a company must answer for a deferrable investment opportunity is how long we postpone the investment up to T time periods. To answer this question, Benaroch and Kauffman (2000) suggested the following decision rule for optimal investment strategy: Where the maximum deferral time is T, make the investment (exercise the option) at time t is positive and attends its maximum value. Of course, this decision rule has to be reapplied every time new information arrives during the deferral period to see how the optimal investment strategy might change in light of the new information. 3.4. A Fuzzy Real Option Valuation We shall introduce a real option rule in a fuzzy setting, where the present values of expected cash flows and expected costs are estimated by triangular fuzzy numbers, and determine the optimal exercise time by using the fuzzy real option model. Usually, the present value of expected cash flows can not be characterized by a single number. But managers are able to estimate the present value of expected cash flows by using triangular possibility distribution of the form
F = [ f l , f m , f r ],

i.e. the most possible values of the present value of expected cash flows lie in the f m (which is the core of the triangular fuzzy number F ), f r is the greatest value and fl is the smallest value for the present value of expected cash flows. In a similar manner one can estimate the expected costs by using a triangular possibility distribution of the form
X = [ xl , xm , xr ],

91

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

i.e. the most possible values of expected costs lie in the interval xm (which is the core of the triangular fuzzy number X ), xr is the greatest value and xl is the smallest value for expected costs. In addition, the values also influence by the financial market, such as riskless interest rate (discount rate) and the volatility of cash inflow. We use historic data to estimate them by using a triangular possibility distribution of the form
R = [rl , rm , rr ], = [ l , m , r ], = [ l , m , r ].

i.e. the most possible values of discount rate, risk-adjusted discount-rate and the volatility of cash inflow lie in the interval rm , m and m (which is the core of the triangular fuzzy number R, and ), rr is the greatest value and rl is the smallest value for discount rate, r is the greatest value and l is the smallest value for the risk-adjusted discount-rate, r is the greatest value and l is the smallest value for volatility of cash inflow. The information needed for capital budgeting is generally not known with certainty. The sources of uncertainty may be the net cash inflow, the discount rate, or the life of the project, etc. Hence in addition to consider the fuzzy volatility and investing cost X , we also consider the fuzzy cash inflow F , fuzzy interest rate and R . In these circumstances we suggest the use of the following formula for computing fuzzy real option values
ROV ( F , X , , R, , T ) = F e T N (d1 )X e R T N (d 2 ).

where
d1 = ln( F X ) ( R 2 / 2) T

, d 2 = d1 T

and where, F denotes the possibilistic mean value of the present value of expected cash flows, X stands for the possibilistic mean value of expected costs and ( F ) is the variance of the present value expected cash flows, stands for the risk-adjusted discount-rate, R stands for the discount rate, T stands for the interval, Using above formula for arithmetic operations on triangular fuzzy numbers we find
FROV = ( f l , f m , f r ) e T N (d1 )( xl , xm , xr ) e R T N (d 2 ) = ( fl N (d1 ) e T xr N (d 2 ) e R T , f m N (d1 ) e T xm N (d 2 ) e R T , f r N (d1 ) e T xl N (d 2 ) e R T ],

Where

d 1 = [(ln f l / x r + rl T r T + l l T / 2 ) / r (ln f r / x l + rr T l T + r r T / 2 ) / l d 2 = d1 T . T ],

T , (ln f m / x m + rm T m T + m m T / 2 ) / m

T ,

In the following we shall generalize the probabilistic decision rule for optimal investment strategy to a fuzzy setting: Where the maximum deferral time is T, make the investment (exercise the option) at time t ; 0 t T , for which the option, Ct , attends its maximum value,

C t = m a x C t = F e T N ( d 1 ) X e R T N ( d 2 )
t = 0 ,1,..., T

Where
Ft = PV (cf 0 , cf1 ,..., cfT , ) PV (cf 0 , cf1 ,..., cf t , ) = PV (cf t +1 , cf1 ,..., cfT , ),

that is,
Ft = cf 0 +

(1 + )
j =1

cf j

cf 0 +

(1 + )
j =1

cf j

j j = t + 1 (1 + )

cf j

where cf j denotes the expected (fuzzy) cash flow at time j, is the risk-adjusted discount rate (or

required rate of return on the project). However, to find a maximizing element from the set
{C0 , C1 ,..., CT } is not an easy task because it involves ranking of triangular fuzzy numbers.

In our computerized implementation we have employed the following function to determine the expected fuzzy real option values {Cl , Cm , Cr }, of triangular form:
E (Ct ) = [(Cr Cl ) + (Cm Cl )] / 3 + Cl where, Cr, Cm and Cl are the largest, middle, and smallest values of the fuzzy real option values.

92

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

4. Computational Method and Example

We give an example to compare and analyze the results of the capital budgeting problem using a fuzzy real option model, where the present values of expected cash flows, expected costs, the discount rate, the risk-adjusted discount rate and volatility of cash inflows are estimated by triangular fuzzy numbers.
Table 1:
Initial Outlay Period 0

Illustration of Conditional-Probability Distribution Approach

Initial Probability P(1) Net Cash Flow Conditional Probability P(2|1) 0.25 Net Cash Flow 2000 Conditional Probability P(3|2,1) 0.2 0.5 0.3 0.2 0.5 0.3 0.2 0.5 0.3 0.3 0.4 0.3 0.3 0.4 0.3 0.3 0.4 0.3 0.25 0.5 0.25 0.25 0.5 0.25 0.25 0.5 0.25 Cash Flow 1000 2000 3000 2000 3000 4000 3000 4000 5000 2000 4000 6000 4000 5000 6000 5000 7000 9000 4000 6000 8000 5000 7000 9000 7000 9000 11000 Joint Probability 0.015 0.0375 0.0225 0.03 0.075 0.045 0.015 0.0375 0.0225 0.045 0.06 0.045 0.06 0.08 0.06 0.045 0.06 0.045 0.0125 0.025 0.0125 0.025 0.05 0.025 0.0125 0.025 0.0125

0.3

2000

0.5

3000

0.25

4000

0.3

3000

10,000

0.5

4000

0.4

5000

0.3

7000

0.25

5000

0.2

6000

0.5

7000

0.25

8000

Firstly, let we refer to Table 1 by Bonini (1975), where we consider a project requiring an initial outlay of $10,000 (Column 1). In each of the following time periods (Columns 3, 5, and 7), the cash flow to be received is not known with perfect certainty, but the probabilities associated with each cash flow in each period are assumed to be known (Columns 2, 4, and 6), so that we are dealing with a case of risk, and not strict uncertainty. We note that Columns (4) and (6) are conditional-probability figures, where the later periods' expected cash flows depend highly on what occurs in earlier time periods. Given our cash flow and simple probability estimates for the periods 1, 2, and 3, we find 27 possible joint probabilities (Column 8), each of which corresponds to a cash-flow series. Thus in the uppermost path we find the joint probability 0.015 being associated with a cash flow of $2000 in Period 1, followed by cash flows of $2000 and $1000 in Periods 2 and 3, respectively. This particular path is the worst possible result; in non-discounted dollar terms there is a 50 percent loss on the investment. At the other end of the spectrum, we find the best possible outcome offers a return $12,945 with a joint probability of 0.0125. The returns and joint probabilities can be calculated similarly for the other 25 possible patterns.

93
Table 2:

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

NPV and Joint Probability
t 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 PVA 4,661.2 5,550.2 6,439.2 6,474.76 7,363.76 8,252.76 8,288.32 9,177.32 10,066.32 8,297.84 10,175.84 11,953.84 12,024.96 12,913.96 13,802.96 14,763.08 16,541.08 18,319.08 13,948.04 15,726.04 17,504.04 16,686.16 18,464.16 20242.16 19,388.72 21,166.72 22,944.72 NPV -5,338.8 -4,449.8 -3,560.8 -3,525.24 -2,636.24 -1,747.24 -1,711.68 -822.68 66.32 -1,602.16 175.84 1,953.84 2,024.96 2,913.96 3,802.96 4,763.08 6,541.08 8,319.08 3,948.04 5,726.04 7,504.04 6,686.16 8,464.16 10,242.16 9,388.72 11,166.72 12,944.72 Probability 0.015 0.0375 0.0225 0.03 0.075 0.045 0.015 0.0375 0.0225 0.045 0.06 0.045 0.06 0.08 0.06 0.045 0.06 0.045 0.0125 0.025 0.0125 0.025 0.05 0.025 0.0125 0.025 0.0125 Standard Deviation 1021.913 1443.632 984.8824 1131.085 1544.94 1008.12 577.6831 741.2431 440.8144 998.557 693.0202 223.0023 240.0801 25.77347 195.4392 372.9275 866.1388 1127.269 105.4258 430.2211 502.9987 582.0294 1220.687 1144.282 713.7123 1290.468 1111.285

While the primary hurdle in this process is in estimating the cash flows and the probabilities, we recognize that it is the NPV figures we are ultimately interested in. Table 2 gives the present value of the cash flows and the net present value of the project for each cash-flow series (PVA), where a constant 4 percent discount rate was employed. When we multiply each joint probability by the expected net present value associated with that probability, we obtain the expected net present value for the project as a whole, there shown to be $2,517.18. If the cash flows probabilities do not know, then the cash flows become an uncertainty case. In X 0 = [9000,10000,11000], R = [0.03, 0.04, 0.05], = [0.02,0.03, 0.04], we can use fuzzy real option to approach the capital budgeting under uncertainty. We use above example and fuzzy real option model to compute the expected fuzzy real option values. From above data, we transform them into the triangular fuzzy number, and then we substitute into following function.
FROV = ( f l , f m , f r ) e T N (d1 )( xl , xm , xr ) e R T N ( d 2 ) = ( f l N (d1 ) e T xr N (d 2 ) e R T , f m N (d1 ) e T xm N (d 2 ) e R T , f r N (d1 ) e T xl N (d 2 ) e R T ],

Where

d1 = [(ln f l / xr + rT r T + l l T / 2) / r T , l

(ln f m / xm + rmT mT + m mT / 2) / m T , (ln f r / xl + rr T l T + r r T / 2) / l T ], d 2 = d1 T .

Table 3:
t 1 2

Expected Fuzzy Real Option Value

F

(F ) 1 = [960,1022,1084] 2 = [1182,1444,1705]

FROV

E(Ct )
-2465 -1678

F1 = [2617,4661,6705] F2 = [2663,5550,8437]

C1 = [-3765,-2532,-1097] C2 = [-5856,-1899,2721]

94
Table 3:
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

Expected Fuzzy Real Option Value - continued
F3 = [4469,6439,8409] F4 = [4213,6475,8737] F5 = [4274,7364,10454] F6 = [6237,8253,10269] F7 = [7133,8288,9444] F8 = [7695,9177,10660] F9 = [9185,10066,10948] F10 = [6301,8298,10295] F11 = [8790,10176,11562] F12 = [11508,11954,12400] F13 = [11545,12025,12505] F14 = [12862,12914,12966] F15 = [13412,13803,14194] F16 = [14017,14763,15509] F17 = [14809,16541,18273] F18 = [16065,18319,20574] F19 = [13737,13948,14159] F20 = [14866,15726,16586] F21 = [16498,17504,18510] F22 = [15522,16686,17850] F23 = [16023,18464,20906] F24 = [17954,20242,22531] F25 = [17961,19389,20816] F26 = [18586,21167,23748] F27 = [20722,22945,25167]

3 = [920,985,1050] 4 = [1005,1131,1257] 5 = [1119,1545,1970] 6 = [906,1008,1110] 7 = [531,578,624] 8 = [731,741,752] 9 = [343,441,539] 10 = [901,999,1096] 11 = [656,693,730] 12 = [-8,223,454] 13 = [-19,240,499] 14 = [-394,26,446] 15 = [-85,195,476] 16 = [205,373,541] 17 = [818,866,914] 18 = [975,1127,1280] 19 = [-43,105,254] 20 = [323,430,537] 21 = [444,503,562] 22 = [523,582,641] 23 = [1018,1221,1423] 24 = [1025,1144,1263] 25 = [702,714,726] 26 = [1125,1290,1456] 27 = [1035,1111,1188]

C3 = [-3387,-1480,809] C4 = [-4545,-1352,2483] C5 = [-6851,-744,7922] C6 = [-3896,-473,3729] C7 = [-3198,-408,2833] C8 = [-1163,-25,1368] C9 = [-5432,295,7906] C10 = [-3972,-266,4316] C11 = [-2140,433,3541] C12 = [842,2152,3717] C13 = [770,2196,3899] C14 = [6765,2773,9496] C15 = [1619,3313,6015] C16 = [-5411,337,11259] C17 = [-1135,2400,7003] C18 = [-3213,2656,11864] C19 = [1334,3211,5723] C20 = [-4289,1435,11019] C21 = [-2794,2333,9709] C22 = [-2547,2122,8664] C23 = [-3453,2263,12298] C24 = [-2345,2840,10969] C25 = [493,2736,5643] C26 = [-2703,2802,12303] C27 = [29493,74345,165301]

-1353 -1138 109 -213 -258 60 923 26 611 2237 2289 6345 3649 2062 2756 3769 3423 2722 3083 2747 3702 3821 2957 4134 4070

where, t: time(in years), F :cash flow, ( F ) : variance of the present value expected cash flows, FROV : fuzzy real option value, E (Ct ) : expected fuzzy real option value.

When the environment is uncertainty, with uncertain cash flows, the investor will face a distribution of future cash flows rather than a single-point estimate of future cash flow in each period. The method utilized to deal with these uncertain cash flows is that of the fuzzy real option model. What would option valuation make of the same case? To begin with, such a valuation would recognize the importance of uncertainty, which the NPV analysis effectively assumes away. We use the fuzzy real option model to evaluate the project in the same case, which holding the option also obliges one to incur the annual fixed costs of keeping the reserve activelet us say $300, This represents a dividendlike payout of three percent (i.e. 300/1000) of the value of the assets, in the discount rate is around 4%, cost is around $10,000 and dividend rate is around 3%, then we obtain the expected fuzzy real option values for the project as a whole, Ct = t =maxT Ct , where the maximum deferral time is T=27, make the 0,1,...,

investment (exercise the option) at time t ; 0 t T , for which the option, Ct , there shown to be $6,345 at t=14, which is positive and attends its maximum value.

95

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012)

5. Conclusions
The FROV will increase with the current value of increasing expected cash flows estimates. A proactive management can Influence this by developing market strategies to enhance the sale and save the cost. If volatility of cash flow will increase, then the FROV will increase. The corporate management can be proactive and find the ways to expand to new markets, product innovations and innovation product combinations as end results of their strategic decisions. The longer the time to maturity, the greater will be the FROV. A proactive management can make sure of this development by maintaining protective barriers, communicating implementation possibilities and maintaining a technological lead. On the other hand, if the expected value of fixed costs goes up, the FROV will decrease as opportunities of operating with less cost are lost. This can be countered by using the postponement period to explore and implement production scalability benefits. An increase in risk-less returns will increase the FROV, and this can be further enhanced by closely monitoring changes in the interest rates. The FROV will decrease if value is lost during the postponement of the investment, but this can be countered by either creating business barriers for competitors or by better managing key resources. The fuzzy capital budgeting approaches allow cash flows estimate as fuzzy numbers and offer the means to integrate trend data into cash flows. Fuzzy cash flows can better reflect the uncertainty in the project. The integration of qualitative information into the process gives better support. The real option approach also supports the determination of the timing for the investment, and offers a comprehensive way of presenting value of possibilities opened by the project, which is further enhanced with frequently updated fuzzy cash flows. Finally, we would like to stress that advanced decision methods such as real options and fuzzy capital budgeting open the chance to explore the value of flexibility inside and outside a project, and give further insight into the real uncertainty of large investments. The uncertainty is genuine, i.e. we simply do not know the exact levels of future cash flows. Without introducing fuzzy real option model it would not be possible to formulate this genuine uncertainty. The proposed model that incorporates subjective judgments and statistical uncertainties may give investors a better understanding of the problem when making investment decisions.

References
1] 2] 3] Amram, M. and Kulatilaka, N.(1999), Real options managing strategic investments in an uncertain world, Harvard Business School Press, Boston, MA. Bonivi, C. P.(1975), Comment on formulating correlated cash-flow streams, Engineering Economist, 20: 269-314. Bowman, E.H. and Hurry, D. (1993), Strategy through the option lens: an integrated view of resource investments and incremental-choice process, Academy of Management Review, 18:760-842. Black, F.and Scholes, M. (1973), The pricing of options and corporate liabilities, Journal of Political Economy, 81:63759. Carlsson, C. and Fuller, R. (2002), Fuzzy reasoning in decision making and optimization, Physica Verlag, Heidelberg. Chen, S. N. and Moore, W. T. (1982), Investment decision under uncertainty: application of estimation risk in the hillier approach, Journal of Financial and Quantitative Analysis, 17: 425440. Dahlberg, K. and Porter, R.S. (2000), Get real, Anderson Consulting Outlook Journal, 2:3340. Dixit, A.K. and Pindyck, R.S. (1994), Investment under uncertainty, Princeton University Press, Princeton, NJ. Dubois, D. and Prade H.(1988), Possibility theory, New York: Plenum Press.

4] 5] 6]

7] 8] 9]

96 10] 11] 12] 13] 14] 15] 16] 17] 18]

European Journal of Economics, Finance and Administrative Sciences - Issue 45 (2012) Myers, S. C., and Turnbull, S. M.(1977), Capital budgeting and the capital-asset pricing model: Good news and bad news, Journal of Finance, 32: 321-333. Hillier, F. (1963), The derivation of probabilistic information for the evaluation of risky investments, Management Science, 9: 443-457. Leslie, K.J. and Michaels, M.P.(1997), The real power of real options, The McKinsey Quart, 3:522. Kulatilaka, N. and Marcus, A.J. (1988), General formulation of corporate real options, Research in Finance, 7:183-282. Kulatilaka, N.(1993), The value of flexibility: the case of a dual-fuel industrial steam boiler, Financial Management, 22(3): 271. Lee, Financial Analysis and Planning(1985): Theory and Application, Addison-Wesley Publishing Company. Luehrman, T. (1998), Strategy as a portfolio of real options, Harvard Business Review, 76: 89-99. Benaroch, M. and KauFman, R.J.(2000), Justifying electronic banking network expansion using real options analysis, MIS Quart, 24:197225. Micalizzi, A.(1999), Timing to invest and value of managerial flexibility. Schering Plough case study, paper presented at the 3rd Annual International Conference on Real Options, Wassenaar/Leiden. Myers, S. C. and Turnbull, S. M.(1977), Capital budgeting and the capital-asset pricing model: Good news and bad news, Journal of Finance, 32: 321-333. Nichols, N.A.(1994), Scientific management at Merck,Harvard Business Review, 72:88-99. Merton, R.(1973), Theory of rational option pricing, Bell J. Econom. Manage. Sci., 4 :141 183. Robichek, A. A. N.and Myers, S. C.(1966), Conceptual problems in the use of risk-adjusted discount rates, Journal of Finance,12: 727-730. Trigeorgis, L. (Ed.)(1995), Real options in capital investment: models, strategies and applications, Praeger, Westport, CT. Zadeh, LA.(1965), Fuzzy sets, Information and Control, 8:33853.

19] 20] 21] 22] 23] 24]