Influence of Managers’ Subjective Judgments on Project Abandonment Decision Making

2019 ◽  
Vol 18 (02) ◽  
pp. 419-443 ◽  
Author(s):  
Yuhong Liu ◽  
I-Ming Jiang ◽  
Meng-I Tsai
Keyword(s):  
Real Option ◽  
Net Present Value ◽  
Capital Budgeting ◽  
Decision Makers ◽  
Real Option Valuation ◽  
Fuzzy Process ◽  
Proposed Model ◽  
Managerial Optimism ◽  
High Level ◽  
Unrealistic Expectations

Real option valuation with flexibility under uncertainty has been proposed as an alternative and advantageous complement to the traditional net present value (NPV) method for capital budgeting decisions, yet the problem with unrealistic expectations on precision has still not been solved. It appears clearly that a high level of precision in cash flow estimates can be misleading for the decision makers with sentiments. To the extent that precision surrounds a decision, we introduce a fuzzy process into an abandonment option approach, which is built on the use of fuzzy numbers, to investigate the effects of managerial optimism and pessimism when a manager considers whether or not to abandon capital budgeting decisions under imprecision and uncertainty. From the numerical analyses of the proposed model, we find that an optimistic manager tends to continue executing the project, while a pessimistic manager tends to give up the project and liquidate it as the value of the abandonment option is within the range of a fuzzy sentiments interval. In addition, if the project value is below the lower bound of the fuzzy sentiments interval, then it is better to exercise the abandonment option rather than to continue holding it, for both optimistic and pessimistic managers. Finally, this paper also examines why managers may still continue a project, even if its Tobin’s [Formula: see text] value is smaller than one.

scholarly journals The application of real option valuation techniques in the cellular telecommunication industry in South Africa

2009 ◽  
Vol 40 (3) ◽  
pp. 1-20 ◽  
Author(s):  
M. Mkhize ◽  
N. Moja
Keyword(s):  
South Africa ◽  
Capital Investment ◽  
Real Option ◽  
Net Present Value ◽  
Capital Budgeting ◽  
Base Case ◽  
Telecommunication Industry ◽  
Option Valuation ◽  
Real Option Valuation ◽  
Telecommunication Operators

The purpose of this paper is to examine whether real option valuation techniques can be used by cellular telecommunication operators in South Africa when making capital investment decisions in next-generation service-orientated architectures. Prior studies, in other parts of the world, recommend the use of real option valuation techniques by telecommunication operators when conducting capital budgeting. In this study, both Black-Scholes and Binomial models are used to examine their effectiveness in valuing capital investments within a cellular telecommunication industry in South Africa. Results show that real option valuation techniques are effective in analysing investments in cellular telecommunication industry. Their strengths are mostly demonstrated when determining the value of strategic options that are added to traditional (base-case) net present value. Summary and conclusions are provided.

THE APPLICATION OF REAL OPTIONS THEORY IN DEFENSE R&D PROJECTS: AN EIGHT-FOLD SEQUENTIAL COMPOUND OPTION MODEL

2011 ◽  
Vol 08 (01) ◽  
pp. 95-112
Author(s):  
WON-JOON JANG ◽  
JEONG-DONG LEE
Keyword(s):  
Real Options ◽  
Real Option ◽  
Net Present Value ◽  
Decision Makers ◽  
Policy Implications ◽  
Sensitivity Analyses ◽  
Actual Process ◽  
Real Options Theory ◽  
Real Options Valuation ◽  
Real Option Valuation

Today, despite the needs of more credible valuation models in defense research and development (R&D), defense decision makers mainly focus on previous cost and NPV-based approaches to evaluate them. Defense R&D projects should be considered as a sequential compound real option due to its relevant characteristics. This paper presents a real option valuation model with the use of an eight-fold compound option in the valuation of defense R&D projects and its illustrative application using a case study in the Republic of Korea. Compared to the traditional net present value (NPV) methods and their sensitivity analyses with value drivers, the paper shows the necessity of using real option approaches and their mindsets for defense decision makers to decide their defense R&D projects. The contribution of this paper is to present the real option framework in valuating of defense R&D projects, providing for the managerial flexibility with option mindsets. It also shows some limitations of using cost- and NPV-based approaches and presents real options valuation methods as its solution. The paper suggests some feasible defense policy implications that can be applied to the actual process of defense acquisition projects.

scholarly journals Estimating the optimal market price to sell an apartment

2018 ◽  
Vol 18 (4) ◽  
pp. 319-327
Author(s):  
Carlos Alexandre Camargo de Abreu
Keyword(s):  
Real Estate ◽  
Real Option ◽  
Net Present Value ◽  
Market Price ◽  
Real Estate Market ◽  
Point Of View ◽  
Valuation Theory ◽  
Analysis Model ◽  
Optimal Price ◽  
Real Option Valuation

Abstract This paper demonstrates an investment economic analysis model based on Real Option Valuation Theory applied to decision-making of individual real estate investors. The model captures the valuation of flexibilities caused by expected market trend and uncertainty and offers an optimized value for the investment opportunity. A Real Option for investment delay is used applied to the case of postponing the selling of an apartment until the estimated "best" optimal market price and option value. Application of the model is made using market data from three Brazilian major cities' real estate market. As an important finding we have the estimation of an expanded Net Present Value for the investment when apartment selling is exercised at the optimal market price defined. It is possible to use this model to forecast what would be the optimal price and moment to sell an apartment in an investor point of view.

scholarly journals The Decision To Build A Fence: A Real-Option Problem

1970 ◽  
Vol 36 (1) ◽  
pp. 45-58
Author(s):  
Garland Simmons
Keyword(s):  
Real Option ◽  
Net Present Value ◽  
Programming Model ◽  
Investment Decision ◽  
Economic Value ◽  
Value Added ◽  
Capital Budgeting ◽  
Herd Size ◽  
Cattle Production ◽  
Relationship Of

Real-option methods of Net Present Value (NPV) analysis are applied tounderstand a capital budgeting decision concerning flexibility. The capital budgetingproblem under study here is the decision of whether Spade Ranch (Spade) should builda fence. If this fence is built, then a hay-meadow could be converted into pasture land,which would in turn permit the herd-size of the Spade Ranch to increase. However,this fence building does not require the Spade to take the newly-fenced land out of hayproduction and put it into cattle production. Instead, once the fence is built, the Spadehas the ability to switch land use from hay production to cattle production and viceversa. The decision of whether or not to create this flexibility by fence-building is thecrux of this paper. What is the value of flexibility? If the fence costs less than the valueof this flexibility then we build the fence, otherwise no.For two different scenarios, a linear programming model is employed todefine the relationship of Economic Value Added (EVA) to the question of whetheror not one should produce hay or cattle given that the existence of a fence permits adecision maker to switch back and forth between hay and cattle production. Thesetwo scenarios, each of which work under different pricing assumptions, producedifferent EVA results and different production choices.From this scenario work, the paper moves to the question of NPV. Is thedecision to build a fence a positive NPV investment decision or not? An optionpricing model is used to approach this question. Given a fence that provides for theability to switch back and forth between cattle and hay production, what is the valueof choosing additional cattle production by giving up the additional production ofhay for sale? As it turns out, the question of NPV for an investment that provides afirm more flexibility by switching from the production of one product to another canbe answered. But the answer depends on the volatility of possible rates of return oninvestment for both hay and cattle production, and their correlation with one another.

scholarly journals An analysis of capital budgeting methods, the cost of capital and decision-makers in listed South African firms

2012 ◽  
Vol 9 (2) ◽  
pp. 519-529
Author(s):  
John H. Hall
Keyword(s):  
South African ◽  
Net Present Value ◽  
Cost Of Capital ◽  
Capital Budgeting ◽  
Decision Makers ◽  
Internal Rate Of Return ◽  
Present Value ◽  
The Cost ◽  
Academic Qualifications ◽  
A Company

This study’s purpose was to link the length of decision-makers’ employment in a firm and their academic qualifications to their choice of capital budgeting methods and of cost of capital techniques. The results show that the net present value (NPV) is more popular than the internal rate of return (IRR) as a capital budgeting technique. Also, irrespective of how long respondents have been employed by a company, they all use a discount rate. However, there is a significant tendency among respondents with postgraduate qualifications to prefer the NPV as a capital budgeting technique. Thus, in South Africa, academic qualifications do play a role in decision-makers’ capital budgeting practices.

scholarly journals Real Options and Escalation of Commitment: A Behavioral Analysis of Capital Investment Decisions

2009 ◽  
Vol 84 (1) ◽  
pp. 133-155 ◽  
Author(s):  
Christine A. Denison
Keyword(s):  
Real Options ◽  
Capital Investment ◽  
Net Present Value ◽  
Investment Decisions ◽  
Capital Budgeting ◽  
Decision Makers ◽  
Escalation Of Commitment ◽  
Present Value ◽  
Value Analysis ◽  
Cognitive Accessibility

ABSTRACT: This study uses experimental methods to explore whether incorporating real options into net present value analysis can reduce escalation of commitment, or the tendency of decision makers to continue to commit resources to a project after receiving negative feedback. This reduction in escalation behavior should occur because the incorporation of real options offers the user greater cognitive accessibility to the possibility of project abandonment. Findings indicate that users of real options exhibit less escalation of commitment than do users of net present value analysis alone. The main result demonstrates that the use of real options in capital budgeting can affect the behavior and decisions of the user even in an experimental setting that controls for the informational advantage of using real options.

scholarly journals CAPM‐based capital budgeting and nonadditivity

2008 ◽  
Vol 26 (5) ◽  
pp. 388-398 ◽  
Author(s):  
Carlo Alberto Magni
Keyword(s):  
Decision Making ◽  
Net Present Value ◽  
Investment Decision ◽  
Capital Budgeting ◽  
Decision Makers ◽  
Capital Asset Pricing ◽  
Content Type ◽  
No Arbitrage ◽  
Asset Pricing Model ◽  
Investment Decision Making

PurposeIn investment decision making, the net present value (NPV) rule is often used alongside the well‐known capital asset pricing model (CAPM). In particular, the use of disequilibrium NPV is endorsed in corporate finance for both valuation and decision. The purpose of this paper is to test the reliability of this approach to capital budgeting valuations and decisions.Design/methodology/approachThe use of disequilibrium values for computing a project's NPV is considered, and the consistency with the CAPM is checked. The resulting valuation and decision are contrasted with the no‐arbitrage principle, which is universally considered a benchmark for rationality.FindingsThe paper finds that the disequilibrium NPV is logically deducted from the CAPM for decision‐making purposes. However, this NPV provides nonadditive values, which makes it inconsistent with the no‐arbitrage principle.Practical implicationsThe use of the CAPM+NPV procedure for valuing projects is invalid if disequilibrium values are used. Its use for decision making is logically valid but practically unsafe, because decision makers may frame equivalent courses of action in different ways, resulting in different decisions, which implies that they may incur arbitrage losses.Originality/valueThe literature does not distinguish between equilibrium and disequilibrium NPV nor between valuation and decision. This paper explicitly makes this distinction and the resulting consequences are highlighted.

A FUZZY REAL OPTION VALUATION APPROACH TO CAPITAL BUDGETING UNDER UNCERTAINTY ENVIRONMENT

2010 ◽  
Vol 09 (05) ◽  
pp. 695-713 ◽  
Author(s):  
SHIN-YUN WANG ◽  
CHENG-FEW LEE
Keyword(s):  
Cash Flow ◽  
Real Option ◽  
Capital Budgeting ◽  
Decision Time ◽  
Optimal Decision ◽  
Option Valuation ◽  
Real Option Valuation ◽  
Flow Information ◽  
Present Worth ◽  
Uncertainty Environment

The information needed for capital budgeting is generally not known with certainty. The sources of uncertainty may be the net cash inflows, the life of the project, or the discount rate. We propose a capital budgeting model under uncertainty environment in which the concept of probability is employed in describing fuzzy events and cash flow information can be specified as a special type of fuzzy numbers. The present worth of each fuzzy project cash flow can be subsequently estimated. At the same time, to select fuzzy projects and determine the optimal decision time under limited capital budget, we offer an example to analyze the results of the capital budgeting problem under uncertainty using a fuzzy real option valuation.

scholarly journals Manager’s Flexibility & Cancellation Option: Insights of a Case Study in the Latin American Oil Industry

2017 ◽  
Vol 1 (3) ◽  
Author(s):  
Arthur Ridolfo Neto ◽  
Marcelo Moreira Russo
Keyword(s):  
Real Options ◽  
Latin American ◽  
Real Option ◽  
Net Present Value ◽  
Option Valuation ◽  
Investment Opportunity ◽  
Gas Field ◽  
The Real ◽  
Real Option Valuation

Purpose: This article focused on the main business insights of the use of Real Options valuation analysis in the eyes of a finance professional. It used a case study of an investment opportunity in the oil and gas field services industry in Latin America to discuss the methodology implementation and its insights. As a secondary objective, it discussed the insights and options embedded in this investment opportunity.Methodology: The investment opportunity was examined using the Real Options Analysis (ROA) framework and the results compared to the traditional methodology of Net Present Value. The valuation technique was performed as if it had been applied at the time the project was approved.Findings: The most important of Real Option valuation is not the results, but how one arrives at them. After the project value is calculated and the project approved or not, the Real Option valuation requires and supports the monitoring of the project. By understanding how the options are created, managers can make better decisions about the project after it was approved.Practical implications: A relevant contribution from the study was the discussion, as a practitioner, of the methodology implementation in a real world corporation. Originality & value: The case study evaluated two types of real options: first, the effect of an option to cancel a contract that was assessed from the perspective of the client contracting the project; and second, the option to abandon and defer, from the perspective of the company that will perform the investment to provide the services. By incorporating the cost of the put option that the company puts forth for the client (cancellation option) it reduces the project value by giving flexibility to its clients.

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