Traditional Net Present Value Research Articles

Carbonvestments: Appraising Investments in a Carbonomics Environment

In 2011, Australia introduced a Carbon Pollution Reduction Scheme (or CPRS) that was a cap-and-trade emissions trading scheme for anthropogenic greenhouse gases. It clearly indicated to companies that polluting the environment with carbon emissions will no longer be free. Companies subject to carbon caps under a carbon trading scheme can either invests in carbon sequestration project and or buy carbon credits to offset their carbon liabilities. While Net Present Value (NPV) has been recorded as the most popular appraisal technique used across the globe for project valuation purposes, finance theorist suggests that using real options (RO) analysis is a more superior techniques to value investment opportunities. Using case study data of an early mover in a CPRS scheme, this paper reveals how RO approach provides more strategic insights than traditional NPV in valuing carbon sequestration investments (termed carbonvestments).

Comparison of optimization frameworks for the design of a multi-energy microgrid

The scope of the paper is to investigate different strategies for the design of a multi-energy system considered as a systemic optimization problem. The objective is to determine the best sizes of the energy assets such as electrochemical and thermal storages, cogeneration units, solar generators and chillers. In these cases, the techno-economic optimization is a tradeoff between the operating costs and the capital expenditures in the form of integrated management and design of the system. The paper addresses the challenges of these optimization problems in two steps. The former implements generic piecewise linearization techniques based on non-linear models. That approach allows a significant reduction of the computational time for the management loop of the assets (i.e. optimal power dispatch). The latter takes into consideration the integration of that management loop in different architectures for optimal system planning. The main contribution of the paper toward filling the gap in the literature is to investigate a wide range of optimization frameworks - with bi-level optimizations (using both deterministic and evolutionary methods), Monte-Carlo simulations as well as a performant ‘all-in-one’ approach in which both sizes and controls are variables of a single mathematical problem formulation. Finally, a thorough results analysis highlights that the best solution tends to be the same whether the objective to optimize is the traditional net present value at the end of the system lifespan or the total yearly cost of ownership.

Corporate sustainability and stakeholder value trade‐offs in project selection through optimization modeling: Application of investment banking

AbstractThis study presents a new optimization model for quantitative sustainability measurement in net present value estimation process of corporate investments. Proposed model presents an innovative perspective for the transformation of the logic behind traditional investment project selection practices to the sustainable project selection in corporations. By using the proposed model, it is possible that investors' can find positive sustainability trade‐offs without harming returns on investment. A case study is presented to illustrate the applicability of the proposed model in project selection decision‐making processes. Expected net present value is employed to calculate the return of the project investment for project selection decision‐stage. In order to identify stakeholder value trade‐off gaps, proposed model with sustainability involvement is evaluated in contrast to the traditional net value method estimations of the model. Based on optimization results, comparative analysis of proposed sustainability cost involvement in net present value estimation with traditional net present value estimation in project selection practices restore positive trade‐offs verifying the efficiency of proposed methodology.

Real Options Analysis as an Economic Evaluation Method for Rainwater Harvesting Systems

Rainwater harvesting systems (RWHSs) are increasingly employed to reduce the impact of water scarcity in urban buildings. Implementation depends on their financial feasibility, which is generally assessed using discounted cash flow methods. However, these techniques do not consider uncertainties in demand, rainfall, and water tariffs, which can have considerable effects. This work aims to apply real options analysis (ROA)—which evaluates options by establishing ta value for flexibility—to determine the feasibility of RWHSs. A case study incorporating management flexibility was conducted in three university buildings; it showed that uncertainty can present a strategic opportunity based on the possibility of RWHS expansion. The traditional net present value (NPV) and option value were calculated and compared with the result that ROA increased the NPV by more than five times. Thus, it was confirmed that options pricing increases projects’ values and presents opportunity gains for investments, especially when NPV without flexibility is close to zero. With ROA, systems that do not appear to have economic returns with conventional analysis may become feasible. Therefore, ROA is expected to replace conventional methods in RWHS investment decisions, as it can incorporate uncertainties, making the systems more economically attractive.

To College, Or Not To College: An Individualized Approach to Human Capital Investment

The decision to attend college is a question of human capital investment. However, resources to help practitioners frame human capital investment decisions remain elusive and few include the “gold standard” of finance: Net Present Value (NPV). Can one discuss human capital investment with an average adolescent using a traditional NPV approach? Motivated by this question, we presented 10 barriers to maximizing education-career NPV (e.g., clarity of costs, immature adolescent brains, individual discount rates, etc.). We outline an iterative, research-based approach to education-career investment, including: framing the conversation; calculating paired NPVs, and structuring the decision. This multi-step framework leverages practitioner expertise to help adolescents consider the lifelong financial wellness implications of human capital investment.

Influence of Managers’ Subjective Judgments on Project Abandonment Decision Making

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.

The Real Options Lattice: An Alternative to Discounted Cash Flow

Real options methods determine value of a proposed project. In some ways, real options resemble the common net present value method; the net of expected future cash flows is discounted to the present (in today’s currency). For example, one would select projects with a projected net present value (NPV) greater than zero, when future cash flows exceed expenditures. When proposed projects are mutually exclusive, the highest NPV determines the winner. However, real options expand the traditional NPV formula and open up a wider range of choices. The tools of real options analysis include both discrete and continuous stochastic analysis, partial differential equations, Black-Scholes modeling, and decision trees. Of these methods, the lattice-type tree offers the simplest means to value and explain real options. This paper will demonstrate real options analysis using the recombining binomial lattice, and present a sample project scenario. (This is the original work of the authors and not previously published.)

Real options, multi-objective optimization and the development of dynamically robust adaptive pathways

In cases, which are characterized by deep uncertainty it is appropriate to develop dynamic and adaptable plans. This paper presents an approach that uses multi-objective genetic algorithms to automate the development of dynamic adaptation pathways for stormwater management for a tropical urban catchment located in Singapore. Pathways spanning a range of climate and landuse scenarios are developed. Three objectives, namely the economic value of flexibility or the real options value, the traditional net present value and flood robustness are balanced to develop the pareto optimal pathways. Given that the pathways are developed under a blanket of uncertainty it is certain that results will have to be re-computed at different time steps in the future. The assessment performed in this manner offers the ability to recompute results easily when adaptation becomes necessary. Comparison of the results obtained for the different landuse scenarios show that if done right, landuse planning can serve as a solution rather than a problem to cater to a changing climate. This notion coupled with the individual adaptation pathways enables the development of an adaptation strategy that helps outline short and long-term policies necessary to cater to an uncertain future.

Assessment of investment decision in the dry bulk shipping market based on real options thinking and the shipping cycle perspective

ABSTRACTAs the dry bulk shipping market seems to have been stuck in a trough period for a long time, investors need to pay more attention to their investment strategies to survive during this period. This study aimed to find a suitable model to assess dry bulk ship investment decisions in the tough and peak periods based on real options theories. Two options, involving an abandonment option and a deferrable option, were used to define investors’ responses to the uncertainty in investment processes such as stopping or selling vessels. The option valuation was solved by using a binomial valuation model, due to data limitations. In accordance with shipping cycle theories, different volatility parameters for the tough and peak periods were calculated using a generalized autoregressive conditional heteroskedasticity (GARCH) model. The application of the real options model to a case study involving secondhand ship trading indicated its viability. According to the results of the case study, the new model has advantages over the traditional net present value (NPV) method in uncertain investment environments. Thus, the results demonstrate that the real options model is a more suitable method for use in the current dry bulk shipping market.

Valuation of CCS investment in China's coal‐fired power plants based on a compound real options model

AbstractA two‐stage compound real options model is proposed to evaluate carbon capture and storage (CCS) investment decision making from the perspective of coal‐fired power plants, considering the phased nature of CCS technology. A newly built coal‐fired power plant is used as a case study for the application of the compound real options model. The results indicate that the compound real options approach has an advantage over both the traditional net present value (NPV) and single‐option method when handling multistage investments. Although the present carbon price level is not high enough to encourage CCS investment, the critical carbon price will decrease when considering the upside potential inherent in the CCS investment. Further analyses indicate that the timing of the second phase of a CCS project and other factors will also affect the critical carbon price and the value of a CCS investment. These findings will be useful for decision making associated with CCS investment, and related policy making in an uncertain environment. © 2018 Society of Chemical Industry and John Wiley & Sons, Ltd.

Appropriate timing for SMEs to introduce an Internet-based online channel under uncertain operating costs: a real options analysis

This study analyzes the strategic decisions of small- and medium-sized enterprises (SMEs) to determine their optimal timing for introducing an Internet-based online channel when faced with uncertain operating costs. Introductory threshold, option value of waiting, and expected waiting time are derived by constructing value functions for SMEs who consider introducing an Internet-based online channel in addition to a traditional brick-and-mortar channel when faced with uncertain operating costs through traditional net present value method and real options approach. In order to facilitate the use of the proposed models in practice, we propose a parameter estimation method for the uncertain operating costs according to historical data of the actual operating costs, and explain the procedures involved in the whole process of how our models can be used in practical applications. Furthermore, we examine the effect of various parameters, such as awareness of consumer consumption on the Internet, irreversible sunk investment cost, cost efficiency coefficient, risk-free interest rate, mean drift rate and uncertainty rate of the uncertain operating costs, on the optimal timing for the introduction of an Internet-based online channel. In this study, the strategic decision-making of optimal timing for introducing an Internet-based online channel under uncertain operating costs is investigated from a new perspective by seeing the introduction of an Internet-based online channel under uncertain operating costs as a real option. This paper is part of a growing literature in the field of distribution channel management at the intersection of operations and finance. This study enriches the research stream of dual-channel sales mode and expands the scope of application of the real options approach. The models and findings presented in this study can provide theoretical support and practical guidance for SMEs to decide whether and when to introduce an Internet-based online channel when faced with uncertain operating costs in practice.

A Concession Period and Price Determination Model for PPP Projects: Based on Real Options and Risk Allocation

Concession period of PPP (Public–Private Partnership) projects is the most essential feature in determining the time span of various rights, obligations and responsibilities between the government and concessionaire. Most traditional methods are based on the analysis of the future cash flow to determine the concession period, but either ignored the potential values or the risks that might emerge during the project life span, thus failing to find the proper concession period for the project. This paper builds a new model taking both recognized real option value and risk into concession period decision-making, and considering the distribution coefficient of option value, which uses game theory integrated with risk sharing, which increases the flexibility of the negotiation. Real option theory is introduced based on traditional NPV (Net Present Value); its potential value and strategic importance are further exploited. A case shows that the project concession period and the price of the sewage disposal are different when considering option value and risk sharing simultaneously and respectively, which give the two side’s references during negotiation. Allocating the option value and the risk properly between the government and concessionaire can also avoid dispute and promote cooperation.

Forest management decision making based on a real options approach: An application to a case in northeastern Argentina

AbstractThe Net Present Value (NPV) approach is widely applied to assess forest investments, but this method has serious shortcomings, which we propose to overcome by switching to the assessment through the Real Options Approach (ROA). The model in this paper starts with the simulation of the forest’s growth, combined with the projection of the products’ prices and valuing the assets using a binomial model. We include an option of postponement, determining the optimal period of felling. We find that ROA is more robust than the NPV approach because it relaxes the assumption of constancy of both the prices and the discount rate, allowing the determination of the optimal time of felling based on the growth rate of either the forest or the prices of its products. Contrary to the traditional NPV approach, the results obtained with ROA exhibit longer harvest turns and consequently higher profits. The key variable in the ROA, the Real Option Value (ROV) can be shown to be less (albeit moderately) sensitive to decreases of the discount rate than NPV. Moreover, ROV is moderately sensitive to decreases in the price of logs and is negligibly affected by rises in the costs of harvesting, loading and transporting rolls.

The Value of Flexibility at Global Airlines: Real Options for EDW and CRM

Technology projects are inherently risky; research shows that large IT projects succeed as originally planned only 28 percent of the time. Building flexibility, or real options, into a project can help manage this risk. Furthermore, the management flexibility of options has value, as the downside risk is reduced and the upside is increased. The case is based upon real options analysis for an enterprise data warehouse (EDW) and analytic customer relationship management (CRM) program at a major U.S. firm. The firm has been disguised as Global Airlines for confidentiality reasons. The data mart consolidation or EDW marginally meets the hurdle rate for the firm as analyzed using a traditional net present value (NPV) analysis. However, different tactical deployment strategies help mitigate the risk of the project by building options into the project, and the traditional NPV is expanded by the real option value. Students analyze the different deployment strategies using a binomial model compound option Excel macro, and calculate the volatility using Monte Carlo analysis in Excel. A step-by-step tutorial is provided to teach students how to accomplish the real options analysis for a simplified project, and this tutorial is easily generalized by students to the case scenario. In addition to the tactical options, the case also has the strategic growth option of analytic CRM. Students must therefore analyze both the tactical and strategic growth options and make a management recommendation on funding the project and also recommend an optimal deployment strategy to manage the project risk.The case teaches real options for technology projects. Students learn how to calculate real option values, where the key input of volatility is obtained by Monte Carlo analysis in Excel. Students also learn that the real option value is “real,” resulting from active management mitigating the risk of the project and improving the upside. Most important, students understand the difference between tactical vs. strategic growth options and the important management issues to consider.

A real options approach to analyse wind energy investments under different support schemes

A real options model is developed to evaluate wind energy investments in a realistic and easily applicable way. Considering optimal investment timing and sizing (capacity choice), the model introduces a capacity constraint as part of the optimisation. Several correlated uncertainty factors are combined into a single stochastic process, which allows for analytical (closed-form) solutions. The approach is well suited for quantitative policy analysis, such as the comparison of different support schemes. A case study for offshore wind in the Baltic Sea quantifies differences in investment incentives under feed-in tariffs, feed-in premiums and tradable green certificates. Investors can under certificate schemes require up to 3% higher profit margins than under tariffs due to higher variance in profits. Feed-in tariffs may lead to 15% smaller project sizes. This trade-off between faster deployment of smaller projects and slower deployment of larger projects is neglected using traditional net present value approaches. In the analysis of such trade-off, previous real options studies did not consider a capacity constraint, which is here shown to decrease the significance of the effect. The impact on investment incentives also depends on correlations between the underlying stochastic factors. The results may help investors to make informed investment decisions and policy makers to strategically design renewable support and develop tailor-made incentive schemes.

Evaluating the Investment Benefit of Multinational Enterprises’ International Projects Based on Risk Adjustment: Evidence from China

This study examines the international risks faced by multinational enterprises to understand their impact on the evaluation of investment projects. Moreover, it establishes a ‘three-dimensional’ theoretical framework of risk identification to analyse the composition of international risk indicators of multinational enterprises based on the theory of an enterprise’s international development path and stages as well as risk management. Using entropy weights and net present value (NPV), this study employs survey data to empirically analyse the international risk entropy evaluation model and then test the NPV evaluation model based on risk adjustment. A significant difference is found between the evaluation process of multinationals’ international investment benefits with and without considering the risk factors. This study concludes that the results of the risk-adjusted NPV model are more scientific and effective than that of the traditional NPV model as the basis of decision-making. It contributes to the theoretical literature by proposing the international risk entropy model and constructing the risk-adjusted NPV model to test the impact of international risk factors on the evaluation of international investment projects. This provides a reference to multinationals in their choice of investment projects as well as to researchers in this field.

Oil Project Selection by Metrics

The recent fall in oil prices has led to extensive capital rationing, and thereby given rise to a renewed focus on parameters for project selection which supplement net present value. While the financial crisis was creating capital constraints, the oil industry seemed to be paying great attention to the net present value index. The metric most often referred to at present, given the prevailing uncertainty over the direction of future oil prices, seems to be the breakeven price of a project. Management and professionals in the oil and gas sector, as well as industry analysts, appear to be very concerned about which criteria in addition to net present value other companies are applying in their decision-making. Our findings indicate that they can be more relaxed here, since the various supplementary criteria provide very similar rankings. We examine the different investment metrics of a portfolio of oil projects. The analysis of project metrics shows that the overall grouping of projects is the same with the three supplementary metrics. The concentration by the companies on robustness related to oil prices means that particular attention is paid to the breakeven price and cost optimisation. Projects which are optimised and sanctioned may have a very high return with the realisation of an expected price scenario. We introduce a new metric, referred to as the complete net present value index, which improves the traditional net present value index by including operating expenditure and by treating taxes in a consistent manner.

Oil Project Selection by Metrics

The recent fall in oil prices has led to extensive capital rationing, and thereby given rise to a renewed focus on parameters for project selection which supplement net present value. While the financial crisis was creating capital constraints, the oil industry seemed to be paying great attention to the net present value index. The metric most often referred to at present, given the prevailing uncertainty over the direction of future oil prices, seems to be the breakeven price of a project. Management and professionals in the oil and gas sector, as well as industry analysts, appear to be very concerned about which criteria in addition to net present value other companies are applying in their decision-making. Our findings indicate that they can be more relaxed here, since the various supplementary criteria provide very similar rankings. We examine the different investment metrics of a portfolio of oil projects. The analysis of project metrics shows that the overall grouping of projects is the same with the three supplementary metrics. The concentration by the companies on robustness related to oil prices means that particular attention is paid to the breakeven price and cost optimisation. Projects which are optimised and sanctioned may have a very high return with the realisation of an expected price scenario. We introduce a new metric, referred to as the complete net present value index, which improves the traditional net present value index by including operating expenditure and by treating taxes in a consistent manner.

SEQUENTIAL CAPITAL INVESTMENT DECISION MAKING UNDER EXTREME CASH FL OW SITUATIONS: EVIDENCE USING MONTE CARLO SIMULATION

Uncertainty influences a decision maker's choices when making sequential capital investment decisions. With the possibility of extremely negative cash inflows, firms may need to curtail operations significantly. Traditional Net Present Value analysis does not allow for efficient management of these problems. In addition, firm managers may behave irrationally by accepting negative Net Present Value projects in the short term. This paper presents a Monte Carlo simulation based model to provide policy insights on how to incorporate extreme cash flows and manager irrationality scenarios into the capital budgeting process. This paper presents evidence that firms with irrational managers and experiencing extremely negative cash flows may, under certain conditions, reap long term rewards associated with the acceptance of negative Net Present Value projects in the short term. These benefits are largest if cost ratios (discount rates) are small, or investment horizons are high. We argue that acceptance of short term negative Net Present Value projects implies the purchase of a long term real option which can generate positive long term cash flows under certain conditions.

Study on carbon capture and storage (CCS) investment decision-making based on real options for China's coal-fired power plants

In this paper, a quadrinomial model based on the theory of real options is developed to evaluate the investment in carbon capture and storage (CCS) retrofitting for existing coal-fired power plants in China. Uncertainties in carbon price, fossil fuel price, investment cost and government subsidy are considered. An existing typical 600 MW supercritical pulverized coal-fired (SCPC) plant is taken as a case study to illustrate the proposed model, and the effects of government subsidy under different scenarios on the critical carbon price to invest in CCS are analyzed. The results indicate that the real options approach has an advantage over the application of traditional net present value (NPV) method when handling uncertainty. And government subsidy has significant effects on reducing critical carbon price for investment in CCS. The critical carbon prices are 103.56 RMB/ton with 100% subsidy and 217.95 RMB/ton without subsidy, while the current average carbon price is 85.2 RMB/ton. This means that the current trading environment is not positive enough to attract investment in CCS retrofitting. These conclusions provide theoretical foundation for decision-making of CCS investment and related policy-making.