Capital Budgeting Technique Selection through Four Decades: With a Great Focus on Real Option

Capital budgeting investment decisions involve the use of a large portion of a firm’s assets; actually no decision places a company in more jeopardy than these decisions. Often these investments can cost billions of dollars, and require predictions of the future, without a suitable return the very existence of the company can be compromised. This paper aims to provide a review and analysisoncapital budgeting techniquesfrom 1970 to 2012 in developing and developed countries regarding the most effective factors on selecting techniques. It also analyzes how industries proceed to more sophisticated techniques during four decades. The most important flaws of traditional methods were criticized to analyze whether adopting a new sophisticated method like real option (RO) could eliminate them. Through an overview on RO domain and its process, the most efficient usageof sophisticated methodswas found.Reviewing previous empirical studies on real option adoptiongive us insight for providing required infrastructures before applying real option process. Our main aim by providing this paperis to help readers makethe most appropriate decision about capital budgeting techniques in terms of different factors with a great focus on real option (in the case which real option domain would not be contravened)and fault detecting to remove important obstacles and achieve successful real option implementation.

capital budgeting practices including real option valuation is reviewed. Section 3 mentions the most important deficiencies of traditional methods and potential benefits of real option logic torecover them,Section 4 notes RO domain, application and it's process, Section 5 comprises overviewing someprevious surveys and paperson RO adoption. In this section industries, uncertain parameters, options, and reasons for adopting are assessed, and section 6 provides summery and conclusions.

Literature Review of Capital Budgeting Practices
A lot of surveys have been done all around the world about capital budgeting practices and the most effective factors on investment appraisal technique's selection. Numerous authors have assessed adoption of DCF methods in investment appraisal (e.g.: Boersema (1978), Rosenblatt and Jucker (1979), Aggarwal (1980), Ross (1986) in America and Sangster (1993) in the UK).
One of the good one was presented In1969 by Mao. He compared capital budgeting in theory and practice. In his survey, among eight companies which questioned about most used capital budgeting techniques, following result were found (table 2.1). He said "Payback period is primarily a risk measure.Accountingprofit is especially important if the company is widely held and relies on external sources of financing. Internal rate of return is most likely to be the major criterion in closely held firms which are less worried by erratic patterns in their per share earnings, which finance themselves and which make many small investments so that the risk in any one investment is not critical." Growth companies with closely held stock which finance growth through internal generation of funds and whose typical investment are small in relation to the total resources of the firm 4 Internal rate of return, payback period and accounting profit Publicly held companies which rely heavily on external sources to finance growth and whose businesses are fairly risky and competitive 2 payback period, accounting profit, and exposure index They are similar to the above four in terms of stock ownership and in their reliance on outside capital, but their investments are more risky because of strong industry competition and because of their few, but large investments.
Along these surveys Pike (1996) reported the findings of a longitudinal capital budgeting study based on surveys conducted between 1975 and 1992 compiled by conducting cross-sectional surveys on the same firms at approximately five year's intervals. He drew a sample of 208 firms from the largest 300 UK quoted companies as measured by market capitalization then he represented his findings in table 2.2. He believed that increased awareness of the time-value of money in decision making and increasing use of computer spreadsheets may have assisted in using NPV rapid growth. Although there had been a clear movement toward greater sophistication, the increase was significantly greater for larger firms than for smaller ones he stated that, this does not necessarily mean that it is company size that determines the degree of capital budgeting sophistication in firms. But the use of computers in capital budgeting was a powerful moderating variable in explaining sophistication levels.
www.ccsenet.org/ijbm International Journal of Business and Management Vol. 7, No. 17;2012  They also asked questions concerning if and how risk was taken into account when evaluating projects. Over fifty percent of the firms indicated they did specifically differentiate project risk by either grouping projects into risk classes or individually measuring project risk then the methods used in this regard were assessed. Their Results are shown in table 2.5.   (Ryan & Ryan; Responses to the question:" please classify how frequently your firm utilizes each of the following budgeting tools: "often" would generally mean that you use this tool about 75% of the time, "sometimes" would refer to about 50%, and "rarely" would mean about 25% of the time.   (Ryan & Ryan; Responses to the question:" please classify how frequently your firm utilizes each of the following budgeting tools: "often" would generally mean that you use this tool about 75% of the time. "sometimes" would refer to about 50%, and "rarely" would mean about 25% of the time.  He also considered some non-financial criterion and the capital budgeting plans period in his work.As table 2.9 represents Most of respondent interested in short term investment.So by those evidences, lack of real option adoption has not been surprising. Among these researches, Block (2007) focused exclusively on real options and capital budgeting.In his survey of Fortune1000 companies, the 40 users of real option came mainly from industries where sophisticated analysis was the norm, such as technology, energy, and utilities. Further, he foundthat industry classification had a significant relationship to the use of real options but did not have a significant relationship to the techniques used.We further represent his findings in section 5.
More effective factors on capital budgeting were assessed in another study presented in 2008. Leon et al(2008) reported the results of a survey on executives from companies listed on the Jakarta Stock Exchange.   Method never or occasionally (0-2) -frequently or always (3-4) They also made a comparison between the usage of capital budgeting techniques in Swedish companies and companies in U.S and continental Europe (figure 2.2). Andoret al (2011), in their study reported the results from executives of companies in ten countries in Central and Eastern Europe (CEE) (Bulgaria, Croatia, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia). In their study three factors have been assessed: firm size, multinational culture and insider ownership. They also made a comparison between the CCE and developed countries.
Baker et al (2010) assessed a large sample of Canadian firms to first learn whether they use real options, the types of real options used, and why firms do or do not use this method. We return to their results in section 5.
However 30 years passed from Real option logic emersion but as we can see adoption of RO as an investment appraisal technique have been very slow.So despite lots of researches have been done criticizing traditional methods we are going to investigate the most important ones and whether RO logic could cover them.

What's Wrong with Traditional Approach? How Does Real Option Handle These Flaws?
Traditional approaches to strategic investment appraisal, payback, accounting rate of return, return on investment (ROI), residual income, and discounted cash flow have been criticized on a number of grounds. Some of the chief criticisms are a too narrow perspective, exclusion of nonfinancial benefits, overemphasis on the short term, faulty assumptions about the status quo, inconsistent treatment of inflation, and promotion of non-value-adding behavior.
www.ccsenet.org/ijbm International Journal of Business and Management Vol. 7, No. 17;2012 First Investment proposals are often viewed through an exceedingly narrow decision-making lens, examined almost regularly from the sole perspective of the investing department. As such, the benefits that materialize outside that department (such as reductions in indirect labor and inventories) are often overlooked (Adler 2000) whereas structure of real option is enhancing value of projects through options valuation (e.g., expansion, contraction, abandonment and so on). Defining such specific options which assess and cover all decision features is impossible without providing experts from different corporation's units which develop dialogues between the various project stakeholders.
A second problem with the use of traditional appraisal techniques is their inability to account for the nonfinancial benefits that frequently characterize strategic investments. In particular, such issues as having greater manufacturing flexibility or being more efficient at providing information are seen as esoteric and are unable to fit into the financial calculus of traditional appraisal models.Likewise, terminal project values that is difficult to quantify, such as investments that pertain to system design, database development, or software, are commonly awarded a value of zero. But such an approach seems highly capricious and foolhardy, especially in light of growing evidence that these investments often provide invaluable organizational learning that can subsequently be applied to other projects (Adler 2000). On one handlack of real work applicability of RO restrict us from saying that ROV could cover this issue for sure, but there are some case studies which quantified nonfinancial benefits like CO 2 emission reduction by assuming climate policy uncertainties innew energies and CCE technology valuation.So to some extent it is about appraisal team's abilityto make a combination of market and rival information, uncertainty and time fordiscoveringa proper option.On the other hand using nonfinancial benefits (which could subsequently be applied to other projects) is about long term capital budgeting plan which is the base of strategic decision making and also RO logic.
A third problem with traditional techniques adoption is in discounting cash flows, which benefits should be discounted at a market risk-adjusted discount rate like the WACC, but the investment cost should be discounted at a reinvestment rate similar to the risk-free rate. Cash flows that have market risks should be discounted at the market risk-adjusted rate, while cash flows that have private risks should be discounted at the risk-free rate. This is because the market will only compensate the firm for taking on the market risks but not private risks. It is usually assumed that the benefits are subject to market risks (because benefit free cash flows depend on market demand, market prices, and other exogenous market factors), while investment costs depend on internal private risks (such as the firm's ability to complete building a project in a timely fashion or the costs and inefficiencies incurred beyond what is projected) In addition, because cash flows in the distant future are certainly riskier than in the near future, the relevant discount rate should also change to reflect this. Instead of using a single discount rate for all future cash flow events, the discount rate should incorporate the changing risk structure of cash flows over time (Mun, 2004). This can be done by real option structure which Payoff itself is adjusted for risk and then discounted at a risk-free rate and risk is expressed in the probability distribution of the payoff.
A fourth problem with traditional techniques is their short-term focus. Many strategic investments take many months, if not years, to become fully operational. The non-discounted cash flow (non-DCF) methods are particularly prone to this problem. They display an impatient regard for long lead times and snuff out such projects in their infancy. The payback method does this very explicitly by requiring very short payback periods, typically two to three years.
Meanwhile, accounting rate of return, ROI, and residual income prematurely kill investment ideas in a more subtle fashion. Managers who evaluateunder one of these latter three techniques are unlikely to invest in projects that require long lead times. The trend toward shorter job and company tenures means managers are never sure they will be around long enough to reap the benefits of their long-term investments.
Exactly why many firms insist on using such high costs of capital is unclear. It is likely, however, that they will be uncertain about the true risk of any particular strategic investment decision (SID). As a consequence, they may adopt a conservative approach that invariably leads to a higher cost of capital (Adler 2000). Long time characteristic of strategic investment and techniques required for considering this characteristic in evaluation were already discussed. Moreover traditional methods usually consider the downside risk of project than upside risk, thus they consider such high cost of capital to represent high level of risk or the risk aversion of investor but real option consider the life time of projects in several steps and then by limiting downside risk in each step and exploiting upside risk provide the most conservative approach in an uncertain environment.This could be used byevery investor with each risk acceptance level.
A fifth problem with traditional SID appraisal techniques is the assumptions that the current competitive position www.ccsenet.org/ijbm International Journal of Business and Management Vol. 7, No. 17;2012 will remain unaltered if the investment is not undertaken. But this assumption is not necessarily true. It is only true if the cost, quality, flexibility, innovation features and special services offered by one's competitors also remain unchanged. Investors need an approach(real option) which could also consider an uncertain, competitive and dynamic condition.As mentioned above RO enhance value by evaluating different scenarios which are product of uncertainty, instability, and time and… Yet a sixth problem is the inability to consider more than one source of uncertainty (which is represented in discount rate). In contrast with traditional SID appraisal techniques, RO could consider uncertainty in capital expenditure, cash flows, discount rate and so on.  Although some of previous problems to some extent could be eliminated through ROV but whether applying this approach in all the cases is conceivable, in next section we are going to argue about RO domain.

Application Domain and RO Process
Not all investment decisions can be framed as options. Four main conditions have to be fulfilled in order for a decision to be appropriate for real option logic: irreversibility, uncertainty, flexibility, and information revelation (Krychowski & V. Quelin 2010).
In case of low degree of uncertainty and irreversibility, the NPV rule is more appropriate than RO (Adner & Levinthal, 2004). Flexibility means that when the option expires, the firm really has the possibility to choose among several alternatives. If there is no other viable alternative, the investment project is a "bet", not an option.On the other hand, if the scope of opportunities is too wide, (either from a technological or from a market perspective) the decision process is more characterized by path dependence than by option logic. Whereas RO approach requires specifying ex-ante the possible project scenarios, exploration activities are difficult to anticipate (Krychowski & V. Quelin, 2010) Finally -The field of supply chain management (multi-year procurement contract, …)

A Five Step Process
Once the practitioner decides that ROA is the right tool for the project under consideration, a five step process can be used to calculate and analyze the option value for the project. (e.g., binomial method).
i. Frame the application: Framing a real option is more difficult than framing a financial option. It involves describing the problem in simple words and pictures, identifying the option, and stating clearly the contingent decision and the decision rule. Trigeorgis (1993) divided the real options into seven categories according to the differences in flexibility: Option to Defer, Staged Investment option, Option to Alter Operating Scale, Option to Abandon, Option to Switch, Growth Option, and Interacting Option. Some applications involve more than one decision or option. For example, chooser options may include abandon, defer, expand, contract, and other options. Compound options involve options on options, which may be parallel or sequential. You must identify these dependencies very clearly. Keeping the problem simple and making it more intuitive will help you communicate the results more effectively to get upper management's buy-in.
ii. Identify the input parameters: The basic input parameters (for the binomial method as an example) to value any type of option include the underlying asset value, strike price, option life, volatility factor, riskfree interest rate, and time increments to be used in the binomial tree. Additional information is required for some of the options, such as expansion and contraction options. iii.
Calculate the option parameters: The option parameters are intermediates to the final option value calculations and are calculated from the input variables (Kodukula & Papudesu, 2006).

iv.
Calculate the option value: Real options analysis (ROA) is far more complex compared to these traditional tools and requires a higher degree of mathematical understanding.There are several techniques to evaluate theoptions as shown in table 4.1.
v. Analyze the results: After the option value has been calculated, the appropriate first step is to compare the net present value derived from the DCF method versus ROA and evaluate the value added as a result of the flexibility created by the option(s).  He also investigated the most used methods for solving real option. As table 5.2 represents Binomial lattice is the most popular approach in real option valuation due to simplicity of usage and explanation to top management.  (Baker et al; This table presents managers' responses on which budgeting techniques Canadian firms use when deciding which projects or acquisitions to pursue based on a five-point frequency scale where 0=never, 1=rarely, 2=sometimes, 3=often, 4=always. Responses are ranked by their means from highest to lowest. The sample size is 214. Percentages may not add up to 100 due to rounding.    As far as we can see reasons mentioned by financial officers was chiefly about providing input data, organizational culture and complexity of solutions' process. As Adler (2000) said one trap managers must avoid is viewing the ease and cost of obtaining information as a reason for choosing or excluding particular investment appraisal techniques. Strategic investment decisions are too important not to receive a full and thorough examination, even if it means more time and expense. Because a firm's competitive fortunes will be affected by the decision made. Managers must remember that what truly matters is not the maximization of short term cash flow but the optimal positioning of the firm for the long run. In table 5.7 we briefly review some case study papers on real option: parameters and options considered, and solution methods applied through evaluation.

Summary and Conclusions
We review different factors affecting appraisal methods selection in a lot of survey conducted in several countries during several years and we show it briefly in table 6.1. Also reassess the most important problems in applying traditional methods mentioned by Adler and the way RO logic could remove them. Wereview the RO domain and its process to find that whether RO logic could be used for any cases. Then we over looktwo surveys which assessing RO adoption in different industries with noting the most important reasons of using or not using RO logic. The reasons are a lot about input data collection than functional limitations. However, due to lack of adoption, RO advantages could not be entirely found and also disadvantages.
An implication of this paper is that firms interested in adopting real options analysis must first provide the infrastructures: changing manager's mindset about the appropriate paradigm for evaluating projects (by hiring external consultant), required expertise (This level of expertise is needed not only by financial analysts but also by top management), smooth, organized process of sharing data and tools like user-friendly software which can handle the modeling complexity.
Nonetheless DCF techniques took decades to become routine in analyzing capital budgeting projects, (it emerged in 1900s and became prevalent among industries in 1980s & 1990s). Considering the sophistication and complexity of real options, this approach is likely to experience a similar evolution.
Our hope in presenting thispaper is to provide both academics and practitioners with greater insight to the state of real option: representing the supporting role of RO as a complementary approach of traditional methods, reviewing reasons for an unsuccessful appraisal under real option gives us insight for removing most deterrent obstacles.