Real options valuation: The modern day technique in capital budgeting and decision-making?

Abstract

Over the years, the discounted cash flow approach (DCF) has been the valuation technique choice of many practitioners, academics and corporate finance managers. Such valuation techniques include the NPV, IRR and Payback. These techniques are widely employed due to their intuition and easy computation. However, these techniques do not tell us what to do next after accepting or rejecting a project. The shortcomings of DCF models are addressed by the Real Option Valuation (ROV). The ROV approach takes into account the stochastic nature of underlying project drivers (such as sales volume and the selling price) and managerial flexibility. This study sought to test the applicability of the real options to value managerial flexibility. Precisely, this paper sought to determine whether ROV serve as adjunct to the existing DCF techniques, or replaces the existing capital budgeting techniques in emerging markets like Zimbabwe. Two embedded options were identified, namely the abandonment and expansion option. The study found out that apart from DCF valuation techniques being currently employed by the firm, they can as well incorporate Real Options Analysis to decision making because if accurately valued and timeously executed, real options do add firm value.