Question

Identify the problems of the discounted cash flow (DCF) analysis for valuing a project and explain why it is important that real options be identified as part of the risk analysis of new investment.

Answer 1

The problems associated with the discounted cash flow analysis are:

1. Estimating the cash flows involves thorough research and involves various metrics which may not result in an accurate estimation of the results.

2. The discount rate used in this method is difficult to quantify and usually involves management bias which in turn does not result in appropriate discounted cash flows.

3. Qualitative factors such as investors perceived risk, market reactions are not factored in the analysis.

Real options provide an alternative to the investment decisions unlike the discounted cash flows which does not provide for any future recourse or options in the future. Real options provide the business with pathways of deferment of the project, abandon, delay, expand , switch resources among others. They provide a dynamic approach to decision making and helps the investors correct the course of action if the earlier decision does not work out.