Use of Real Options Theory in Financial Management/Modeling

At a previous employment environment, the president of the corporation acted on a whim, rather than, conducting a series of testing for his expansion to go into other businesses ventures. Within a few short months, the plan was abandoned for lack of profitability. As an employee, I thought of this as a failure on the owner’s part. However, the Real Options Theory is basically, weighing the outcome for expansion or acquisition utilizing capital investments for future ventures. Consider Real Option theory as a method to remove some of the risk in capital investments. Helpful assistance and decision making can be derived using such charts as the Decision Tree. The decision can be extremely tiresome. Use of Real Options Theory in Financial Management/Modeling Long past are the days, where a company can sit idling waiting for an idea, because while waiting someone else is making the move. The benefits that an older company may experience through experience may not fit into today’s society of technological changes. However, the risk of a company that has existed over 50 years, can they lose to new companies that evolve because of revolutionary changes in the ability to change the course of history. Creating valuable service for consumers and bringing a product or service to market, must be planned to meet the expectations of stockholder profits. Consider the comparison of social networking sites, Myspace and Facebook. Both are considered to be rapidly growing and competitive to increasing in membership. However, rapidly increase the popularity of Facebook and exceeded the expectations within the social network environment. The billion dollar corporation enters the market with more appeal to younger consumer, as well as a variety of other industries. Facebook provided more appeal by allowing the markets to meet the consumer where they were located, rather than wait on the consumer to come to them. As financial managers in the corporate environment decide which project is beneficial to stock holders’, returns on investment, and which should be abandoned or expanded, risk can become a certainty in the outcome. The risk of capital investment in the attempt to take on future debts just because they have a hunch that the business will be a success. The amount of time to construct a business model would save enormous amounts of money before taking on the future project. Gathering data of the competitive market and using past financial accounting statements will be useful, however, with new projects, there will be limitations, but estimation of the percentage values can be constructed. Strategic budgeting and capital investment planning decisions to expand into the future profitability of a company can be agonizing if not properly planned by financial managers. The assets, in addition to capital and distribution, change over long periods of time according to the supply and demand of the consumer markets. The net present value (NPV) of what is available, as far as Return on Assets and the Return on Investment (ROI). Cost projection into buying new equipment, inventory over the long run rather than a short period. Capital resources and budgets are the topics as it relates to using the Real Options Theory in Financial Management Modeling. Financial managers can utilize the Real Options Theory as a series of practical solutions to foresee into the future over several years. New products and the amount of capital to invest as well as the funding needed to make an expansion or either to realize that the project would not work. Theoretically, it is very simple and that many companies would utilize this theory. However, the recap or history of business failures is not seen in the futility of business success. The numbers may not lie. All systems may say go full steam ahead with the plans for expansion; however, there is a business cycle which will prove the business model incorrect. According to Rothbard, (2005), expectation in business fluctuations all the time. There is no need for any special â€Å"cycle theory† to account for them. It is simply the results of changes in economic data and is fully explained by economic theory. Many economists, however, attribute general business depression to â€Å"weaknesses† caused by a â€Å"depression in building† or a â€Å"farm depression. † But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression — a phenomenon of the true â€Å"business cycle. † It is pointless to say, as many people do, that a farm depression will ignite a general depression, because farmers will buy less goods, the people in industries selling to farmers will buy less, etc. This ignores the fact that people producing the other goods now favored by consumers will prosper; their demands will increase. (2005, pp. 6) Both the entrepreneur and large corporations have ideas to expand into new market. The main goal is company profits, either with or without expansion. Business expansion into other industries or international territories with current business. However great the idea may seem at the Real Options application of theory will conclude how fallible an idea with be in implementation. Payback period, cash flows and internal rate of return, as well as long term debt financing are the foundation of provision for utilizing the real options theory. Major growth will not derive from duplication of products that are already in the market place, but to begin with creating superior quality and improvements. Such as Facebook found a better way for people to communicate over the internet. Before Myspace, there were such things as electronic mail. Facebook, the ability to socialize as well as form groups, and fan pages begin with meager begins on a college campus. However, did the owner plan for this growth or was it happenstance. How does the work into the corporate structure for a welding company or maybe a warehouse which manufactures auto parts? Examining the stream of information within the forums, research and development addressed. According to Ketchen et al, (2007), â€Å"entrepreneurship refers to firms' pursuit of superior performance via simultaneous opportunity-seeking and advantage-seeking activities. Both small and large firms face impediments while pursuing strategic entrepreneurship† (2007, p. 71)In other words, rather an entrepreneur or fortune 500 company, Real Options Theory, should be the focus to starting a new business, taking on expansion or abandoning projects. The only difference will be in the amount of capital investments. Kretchen et al, continues to state, Ketchen, et al, (2007), While small firms' opportunity-seeking skills may be strong, their limited knowledge stocks and lack of market power inhibit their ability to enact the competitive advantages necessary to an appropriate value from opportunities the firms choose to pursue. In contrast, large firms are skilled at establishing ompetitive advantages, but their heavy emphasis on the efficiency of their existing businesses often undermines their ability to continuously explore for additional opportunities. (2007, p. 371) There are many three components in which company financial manager should be interested in the expected return on assets (ROA), return on equity (ROE) and debt ratio. Finally, another method of expansion can be with the acquisition of new business that is in operation. As stated by Stefano, Reality is that buyers must have capital available to be competitive in acqu isition negotiations. Accumulating capital may be as simple as retaining earnings in the agency instead of distributing those earnings, which is the equivalent of creating a war chest. The other option is to have a line of credit available from a financial institution. Banks are much more willing to offer financing for acquisitions than in years past. Today many banks are in the insurance business and got there through acquisitions. Insurers are also very supportive of the acquisition process and will uncover acquisition prospects because they like to see their successful agencies growing. Stefano, 2005) As explained by Childs et al, (Sep. , 1998), summarizes several calculation in deductive and calculated reasoning for financial managerial modeling and utilizing the Real Options Theory. They state, â€Å"consider a firm that has the opportunity to invest in two projects (a and b). Investment in each project takes place in two stages: The firm can invest in C1 R (I = a, b) to develop a project, which res olves uncertainty regarding the project’s future profitability; it can then make a further investment of K1, (i= a, b) to implement a project. 1998, p. 308). It is clearly mentions by Childs et al, the â€Å"NPV framework for making capital investment decisions has been extended to recognize the dynamic nature of investment decisions† (Childs, p. 305) According to Miller who goes into greater details of the formulation of providing computations to make a decision, it basically states if one project NPV is greater than 0, then it would be wise to invest in the project or product. Screenshot, (2005, p. 7) Summary Companies can no longer hesitate to make a business decision. However, ecisions that are not planned out utilizing capital assets can also cause undue hardship. It is no longer the large Fortune 500 companies designing the most innovative products and services, but also it can be the small entrepreneur with a grand idea. The markets no longer persuaded by familiar names, but can be mesmerized by new names such as Facebook. Methodology and theoretical planning and measurements can be experimenting with resourceful application s as Real Options Theory. By carefully measuring the logistics of one or more projects and committing or abandoning them all.