56 MANAGEMENT DECISION 33,8
Risk and capital budgeting:
avoiding the pitfalls in using NPV when risk arises
David Brookfield
Attempts to provide an “adjusted” NPV technique as experienced in a live environment
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[1] 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 counter-
intuitive, 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.
Management Decision, Vol. 33 No. 8, 1995, pp. 56-59 © MCB University Press
Limited, 0025-1747
To illustrate this point consider the following example:
A company is considering investing £1,800 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: £300 p.a.
Scenario II: £100 p.a.
Further information suggests that there is an equal chance
of either scenario arising and that once the first saving is
made that this level of saving will continue for the
foreseeable future.
At a discount rate of 10 per cent is this a worthwhile
investment? The standard expected NPV approach would
suggest the following solution:
Scenario I: 0.5 × (300/0.01) = £1,500
Scenario II: 0.5× (100/0.1) = £500.
Additionally with an initial investment of £1,800 there is a
positive NPV of £200. However, not all of the costs
have been incorporated into the analysis and hence a
recommendation to go ahead with the project might be
wrong. The ignored cost is the value of the option to wait
which is “embedded” in the above analysis.
To understand this, suppose the company waits for one
year to see if the level of sales will rise. Based on the
criterion that the company will only invest if the level of
savings reaches £300 p.a. the expected PV of the costs now
becomes (noting that the “present” is now one year later):
Scenario I: 300/0.01 = £3,000.
Thus the NPV becomes 3,000 – 1,800 = £1,200, which is a
£1,000/1.1 = £909 improvement on the previous NPV. This
represents the value of the embedded option to wait.
 RISK AND CAPITAL BUDGETING: AVOIDING THE PITFALLS IN USING NPV WHEN RISK ARISES
Some comments on the applicability of the approach may
be made: first, while it may seem obvious that we should
not use the averaging process implied in taking expected
values when only two one-off outcomes are likely to arise,
the real value of this approach is to extend the analysis
over many outcomes which might be repeatable; in other
words, where the expected value approach is truly valid.
Nothing changes in such a situation: embedded options
can still arise. This example is highly simplified to
demonstrate a point. Second, ignoring the embedded
option as in the standard NPV approach ignores an
opportunity cost of waiting to invest. We avoid this cost by
waiting to invest, which gives rise to a positive real option
value. Finally, if the company has to invest immediately
there is no choice and hence there can be no option. In this
case, the standard NPV approach will provide a solution
on which recommendations may be made. Real options
arise when there is an element of flexibility.
One of the potential benefits of using real option methods
has been the recognition that the use of standard NPV
techniques can lead to very wrong conclusions in the
presence of unrecognized embedded options. The central
role of NPV techniques in financial decision making
therefore makes it imperative that real option structures in
investing opportunities are identified and accounted for. It
turns out that real options can be found in most live
environments where uncertainty/risk, waiting, investment
irreversibility, growth opportunity, asymmetric
information, staged investments, competitor response,
scale economies, project switching, suspension,
abandonment and start-up are important. In fact, we can
include just about the full spectrum of investment decision
making, including those concerning capital budgeting.
The fact that standard NPV techniques do not recognize
these situations – or, at least, cannot deal with them
adequately – is a measure of the caution managers must
exercise in using the technique in a real situation.
Why real options correctly deal with risk in
capital budgeting
One of the first proponents of real option analysis was
Myers[3], who identified that NPV incorrectly calculates
the value of cash flows in an uncertain environment. His
observations concerned the fact that NPV analysis ignores
the time series interactions among contingent investments
and that, consequently, delaying investing may accrue
extra benefits. In this sense, real option analysis
recognizes the incremental (or additional) value arising
from flexibility. The fact that flexibility gives rise to
additional value is a recognition of the altered probability
distribution of potential outcomes and its impact on risk
exposure. Underpinning this is the view that risk is critical
to investment, since without it the maximum return that
could reasonably be expected from an investment is the
risk-free rate.
57
The formalization of the treatment of risk in investment
analysis is one of the principal benefits of the real option
technique. In particular, formalization involves a
recognition of the structure of probable outcomes over
time which can be exploited for strategic investment
purposes. The probability distribution of NPV, which
incorporates the valuation of flexibility, is not
symmetrically distributed as in the certainty-equivalent
NPV case. Consequently, the use of simple risk-adjusted
rates to assess investments in which there is flexibility will
undervalue investments. The asymmetry arises because
certainty-equivalent NPV rules ignore flexibility which
provides protection against future events turning out
differently from expected at the outset. This is important
in the certainty-equivalent NPV case, since certainty
equivalence often presumes an irrevocable commitment to
an investment strategy at the outset. However, because
investors have flexibility over subsequent strategies, the
actual risk of losses from investing are lower than
assumed in a certainty-equivalent NPV environment.
Future losses can be avoided by not investing, for example.
Hence, real option analysis would argue that the
probability distribution of the “true” NPV is skewed to the
right in favour of “profitability”, or positive NPVs. In fact,
the skewed distribution would not be smooth and would
be truncated to the left of the mean to produce an absolute
floor to loss exposure.
In a sense, the recognition of real options embedded in a
financial decision alters the distribution of outcomes that
face budget holders. This is why simulation games which
try to emulate normally distributed outcomes do not
reflect the situation in a live environment. In fact, the
answers from such approaches are not even approximate,
since nearly half of one side of a distribution can become
redundant.
In essence, therefore, real options provide a valuation of
investment opportunities over which final decisions have
yet to be made but which do not have to be made until the
appropriate time. Deciding on the appropriate time is an
extremely important question of strategy. Seen in these
terms, the ubiquity of urgency seems less attractive. If a
manager can avoid making a substantial loss from
undertaking a project in which exit routes are non-existent
(that is, the investment is “irreversible”), it seems sensible
to wait if flexibility in timing is available. The real option
approach is one way this intuition can be formalized and
quantified.
The value of waiting is a reflection of the costs associated
with an irreversible investment. That is, if there is an
element of a sunk cost in an investment, then once the
investment has been made the sunk cost is incurred.
However, waiting will always leave the investor with the
power to make a decision about when to invest. Although
this may appear self-evident, traditional NPV assessment
methods ignore this fact. If an investor is therefore making
investment decisions on the basis of NPV, then it is almost
58 MANAGEMENT DECISION 33,8
certain that miscalculations will be made if embedded
options are not recognized. In this context, the
identification of real options helps to explain the value of
flexibility by demonstrating that managers are not
miscalculating investment outcomes and are acting
rationally, based on a “true” calculation of the NPV of the
project.
Debunking some myths in capital budgeting
Capital budgeting, expressed in terms of standard NPV
techniques, leads to wrong conclusions and also leads to
wrong intuition concerning the investment environment.
Generally, when real options are an appropriate appraisal
technique, important points of principle may need re-
evaluating.
Algebraically, the true value of an investment is given by:
Expanded NPV = Passive NPV + Real option value.
(The terminology is from Trigeorgis[4]). The fact that
options have (mostly) positive values indicates that,
without consideration of the value of flexibility, traditional
(passive) NPV rejects too many opportunities. Even when
a real option environment is recognized, there are some
pitfalls to avoid. Perhaps the most recent and useful
extension of research has been in the compound option
literature where a series of real option values emerge
which recognize the contingent nature of investments.
However, it is important to realize that the addition of real
option values in such a framework is inappropriate, unlike
straightforward NPV additions, because of the
interactivity of option values. For instance, abandonment
of a project midstream rules out subsequent option values
that would have arisen had the alternative been to
continue with the project. Second order interactions may
arise should a real option be exercised (i.e. when the project
is undertaken), as the scale of operations may be increased
so that the values of other real options which are
dependent on capacity will be increased. Interactivity is
not an irrelevant side issue, since identifying the nature of
real option interaction and enumerating the consequences
provides valuable information to management concerning
investment strategies. In sum, ignoring strategic or
operating flexibility leads to missed or badly judged
investment opportunities.
Whether real option analysis is appropriate depends on a
few criteria. Typically, real options have value when the
following are important.
Investments can be deferred
The possibility of deferring an investment facilitates
evaluation of future events when they arise and thus
avoids costly errors (which might arise had the original
strategy been followed through). Consequently, even
negative NPV investments may have worth in such a
scenario.
Moreover, deferring investments reweights investment
timing from the now-or-never NPV approach to one which
recognizes the strategic benefits of waiting. Thus, while
urgency is often a valued part of corporate culture, it may
only mean that managers are losing money at a quicker
rate.
The investment is exposed to risk
Investments need risk to offer a sufficient return to
shareholders beyond the risk-free rate. Real options have
greater value in the face of risk and the possibility of
deferral because of the asymmetry of outcomes previously
discussed.
The benefits of the real option approach can be seen in
terms of the simulation experiments often undertaken to
evaluate risk. Usually, a range of values of NPV are
calculated based on different scenarios which often
produce negative and positive outcomes. If managers can
choose to ignore the negative side of the distribution and
demonstrate that this is a logical thing to do, then the more
variance there is in the distribution the greater is the
project’s exposure to upside potential (or positive risk).
If project timings and outcomes can be manipulated and
constructed (which is implied by flexibility) to take
advantage of the risk potential, and there are financial
benefits from so doing, then it seems clear that managers
would want to undertake risky projects. Furthermore, the
riskiest of projects would be welcomed as long as they
exhibited flexibility.
Interest rates are relatively high
Normally fewer investments would be acceptable in such a
situation because discount rates are also likely to be high.
However, higher discount rates mean that the future
capital necessary to exercise a real option (undertaking a
further contingent part of the project at some future date)
is lower in present-day terms. Thus, investments that have
future growth opportunities will be of particular value.
This observation is a consequence of the fact that, while
some initial investment is nearly always necessary in
undertaking a project, financing a new project may be
done in stages. Staged investments offer the opportunity of
expanding the number of exit routes while lowering the
present value of cash outflows.
The impact of changing interest rates
As mentioned above, real options can arise in a variety of
situations, but their influence is not always obvious.
This point can be illustrated by an example involving
interest rates, as follows.
Suppose that the level of interest rates next period is
uncertain. While it is noted that discount rates are not the
same as interest rates, the interest rate terminology is used
 RISK AND CAPITAL BUDGETING: AVOIDING THE PITFALLS IN USING NPV WHEN RISK ARISES
to highlight the fact that discount rates can change for
extraneous reasons. Assume current discount rates to be
10 per cent and that potential changes in interest rates
mean that next period’s discount rate could change to
either 5 per cent or 15 per cent with equal probability.
Adopting Scenario I cash flows from before as the only
possible cash flows, we have the following cost savings
from an initial investment of £1,800:
Scenario I: £300 p.a., in perpetuity.
The resulting NPV with discount rates at 10 per cent is
therefore £3,000 – £1,800 = £1,200.
Considering only changes in interest rates we see that
discount rate volatility actually increases the present value
of the cash inflows:
(1/1.1) × [0.5 × (300/0.15) + 0.5 × (300/0.05)] = £3,636.
And the NPV = 3,636 – 1,800 = £1,836.
The reason why this is surprising is that the expected
value of next period’s discount rate is equal to this period’s
discount rate at 10 per cent:
0.5 × 15 per cent + 0.5 × 5 per cent = 10 per cent.
This simply recognizes the fact that discounted future
cash flows are non-linearly related to discount rates and
that it is wrong to think in an “average” or “linear” way.
Thus, we obtain the surprising result that interest rate
volatility favours investment. However, there is a second-
order effect in terms of the consequences for the timing of
the investment. This is where we see the complications
arising. First, the two possible discount rate outcomes are
evaluated in NPV terms:
0.5 × [(1/1.1) × 300/0.15] = £909
0.5 × [(1/1.1) × 300/0.05] = £2,727.
And clearly, it will only be beneficial to invest now if
discount rates fall to 5 per cent.
Thus, while expected discount rates are 10 per cent, as
shown, the increase in uncertainty has created an option to
wait which offsets the benefits of investing immediately. In
fact, the investment decision is determined as (assuming
we wait):
(2,727 – 0.5(1,800/1.1)) = £1,909.
David Brookfield is based in the Department of Economics & Accounting, University of Liverpool, UK.
Application questions
(1) How is managerial flexibility addressed in your organization?
(2) Are capital budgeting proposals in your organization flexed according to what outcomes need to be faced, and not
on the whole range of alternatives?
59
The value of the embedded option is therefore £1,909 –
£1,836 = £73. If this is scaled up to reflect the quantities
likely to emerge in a live environment then considerations
of waiting become a financial imperative.
Thus we observe opposing forces arising from changing
discount rates in that interest rate volatility enhances
investment outcomes when discounted, but that the effect
encouraging investment might be outweighed by the
embedded option to wait. Care, therefore, needs to be
exercised in analysing the potential outcome of capital
budgeting proposals when discount rates are likely to
vary.
Conclusion
The purpose of this article is to suggest that the
importance of the incorporation of risk or uncertainty into
investment decisions will not adequately be captured by
simulation experiments which assume a now-or-never
investment strategy with the consequence that risk
exposure is assessed on the basis of a symmetric normal
distribution. This is because the value to waiting is not
evaluated in such calculations and that any investment
decisions based on such techniques might well be
seriously flawed. Technically, standard NPV techniques do
not take into account the fact that the distribution of
outcomes is truncated so as to leave investors exposed
only to upside potential.
The value of the real option approach, therefore, is to
highlight to managers the importance of considering
flexibility, and this might be the most significant benefit
above and beyond the techniques of calculation. The
arithmetic only serves to demonstrate that flexibility
should not be ignored.
References
1. Smith, D., “Incorporating risk into capital budgeting
decisions using simulation”, Management Decision, Vol.
32 No. 9, 1994, pp. 20-26.
2. Dixit, A. and Pindyck, R.S., Investment under Uncertainty,
Princeton University Press, Princeton, NJ, 1994.
3. Myers, S., “Determinants of corporate borrowing”, Journal
of Financial Economics, No. 5, 1977, pp. 147-75.
4. Trigeorgis, L., “A conceptual options framework for
capital budgeting”, Advances in Futures and Options
Research, Vol. 3, 1988, pp. 145-67.