VALUE : Risk and investment analysis
Traditional risk analysis methods are all based on the principle of net present value. They are applicable when all investment decisions are irreversible and projects have no flexibility.
With breakeven analysis, the manager or the analyst tries to understand the level of output and revenues that must be reached in order to break even. It is an important tool for a manager because it can set very clear targets. It is convenient to use this method by considering all fixed costs, including financial expenses.
Sensitivity analysis allows the manager to understand how sensitive the NPV is to changes in assumptions on key value drivers, while holding everything else constant.
Scenario analysis changes multiple assumptions simultaneously. In this manner, the analyst must make some effort in estimating which variables move together as well as the intensity of their relationship. Using the Monte Carlo method, a better idea of the prospects of flows can be obtained by allocating a probability distribution to each of them. Although powerful, the method is not so easy to interpret and can be misused.
The limitations of all these methods become evident when project managers are able to use new information to modify a project that is already underway, i.e. when there is a certain amount of flexibility. In such cases, the industrial manager is in the same situation as the financial manager who can increase or decrease his position in a security given predetermined conditions. An industrial manager can also be compared to a financial manager who holds an option. The flexibility of an investment has a value – the value of the option attached to it. This concrete property of a flexible investment is a real option.
Three factors are necessary to ensure that an investment project actually offers real options:
- there is some uncertainty surrounding the project;
- there is additional information arriving over the course of time; and
- it must be possible to make significant changes to the project on the basis of this information.
A number of different types of real options can be present in investment projects:
- the option to launch a new project;
- the option to expand, reduce or abandon the project; or
- the possibility to defer the project or delay the progress of work.
The study of investments on the basis of their net present value can be expanded thanks to the concept of the real option. The result we obtain by including real options in the analysis is known as expanded net present value. This is the sum of the net present value of the project and the real options attached to the project. The uncertainty inherent in the flexibility of an industrial project creates value, but this uncertainty declines as time goes by. The uncertainty is replaced by the intrinsic value arising from the discounted flows adjusted for the new information.