Question

How do options apply to capital budgeting? Explain and give an example.

Answer 1

Capital budgeting does not end with the decision whether to accept or reject a project using tools like NPV or IRR or payback. It also entails financial managers to make choices of how to increase future cash inflows. Financial managers may also have to make choices of how to decrease future cash outflows. The choices are valued using ‘real options’ analysis. Thus options are used to determine the value of the choices that the managers will have in future and these values can be added to the NPV of the project.

An example will be a situation in which there is an option to abandon the project (or the option of abandonment). This option comes into picture when a firm purchases an asset that it may later resell or put to an alternative use if the future conditions do not turn out favorable (as it was originally envisaged) but becomes rather unfavorable. Thus the option to abandon is similar to put option and finance managers can abandon the project if value derived from the project’s assets is more than present value of continuing project for one period or more than one period.