CHAPTER 13

REAL OPTIONS, INVESTMENT STRATEGY AND PROCESS

Q.1.
A.1.

Explain the important steps in the capital budgeting process.

Capital expenditure includes all those expenditures which are expected to produce
benefits to the firm over more than one year and encompasses both tangible and
intangible assets.
The most important steps in capital budgeting process are
1. Identification, i.e., generation of investment ideas;
2. Development of forecasts of benefits and costs for each and every
investment ideas;
3. Evaluation of each and every ideas to measure whether it is profitable or
not;
4. Authorization by top management or approval authority and
5. Control and monitoring, i.e., reviewing and monitoring of the performance
of investment projects after their completion and during their life.

Q.2.

Is capital budgeting merely a question of selecting investment projects? Defend

your position.
Financial evaluation of capital expenditure proposals help to select highly
profitable projects. In practice, companies give considerable importance to
qualitative factors like market potential, possibility of technology change, trend of
government policies, etc. Judgement and intuition should definitely be used when
a choice is to be made between two or more projects, or when it involves
changing the long term strategy of the company. For routine matter, liquidity and
profits should be preferred over judgement.

A.2.

Q.3.
A.3.

Q.4.
A.4.

What role is played by judgement and qualitative factors in the investment

selection? Is it justifiable?
In addition to the use of the sophisticated techniques for evaluation of capital
expenditure decision, the qualitative factors like urgency, strategy and
environment play significant role.
Vision or judgement of the future, e.g., market potential, possibility of
technology change, trend of government policies, opportunities and constraints of
a particular project, etc., is very critical for the success of the firm adopting the
investment projects. A growing firm maybe able to identify profitable
opportunities without an NPV or IRR computation.
Is there any interface between strategy and the capital budgeting system? Why
should capital budgeting be seen within a strategic perspective?
Most companies consider strategy as an important factor in capital budgeting
decision evaluation. Management should spend its time in improving the quality
of decision in the context of overall strategy, e.g., overall objective achievements
of firm. This approach provides the decision maker with a central theme as a
guideline for effectively allocating corporate financial resources.

Strategic management has emerged as a systematic approach in properly

positioning of firm in the complex environment by balancing multiple objectives,
for example, growth, competition, balance of products, total risk diversification,
and managerial capacity, etc. These reinforce the need for a strategic framework
for problem-solving under complexities and the relevance of strategic
considerations in investment planning. Capital budgeting decision involves large
investment, such as, acquisition of a new business or expansion in a new line of
business. Such decisions are generally handled by top management, and have
strategic importance.
Q.5.
A.5.

Briefly discuss the capital budgeting practices of companies in India.

In India, the investment idea generation is primarily a bottom-up process.
Generally, the majority of investment proposals come from divisional
management and plant personnel.
Indian companies use a variety of methods to encourage idea generation.
The most common methods used are: (a) management sponsored studies for
project identification; (b) formal suggestion schemes, and (c) consulting advice.
In addition, companies search investment idea by review of researches done in the
country or abroad, conducting market surveys, and deputing executives to
international trade fairs for identifying new products or technology. Companies
use arbitrary period of 5 to 10 years for forecasting cash flows on conservative
basis. Companies also do formal financial evaluation of almost three-fourths of
investment proposals. They use payback period criterion, and also IRR and NPV
methods for evaluation of investment proposal. Companies in India have a
tendency to equate the minimum rate with interest rate or specific cost of capital.
Indian companies do not use capital rationing theory to allocate scarce resources.
The approval of investment proposal normally lies with top management.

Q.6.

What are real options? Give examples of real options. How should real option be
evaluated?
Real options are those strategic elements in investments that help creating
flexibility of operations, or that have the potential of generating profitable
opportunities in the future for the firm. Real options provide discretion to
managers to take certain investment decisions, without any obligation, for a given
price. Real options are not confined to real assets only. Patent, R&D, brands etc.
are examples of assets that have a value to the owner.
The option pricing theory provides a framework for valuing strategic
investments. The methods of valuing real options are the same as the financial
options.
An investment with real option consists of two values: the value of cash
flows from the projects assets plus the value of any future opportunity (option)
arising from holding the asset.

A.6.