Most firms do not make explicit use of real option techniques in evaluating investments. Nevertheless, real option considerations can be a significant component of value, and firms which approximately take them into account should outperform firms which do not. This paper asks whether the use of seemingly arbitrary investment criteria, such as hurdle rates and profitability indexes, can proxy for the use of more sophisticated real options valuation. We find that for a variety of parameters, particular hurdle-rate and profitability index rules can provide close-to-optimal investment decisions. Thus, it may be that firms using seemingly arbitrary “rules of thumb” are approximating optimal decisions.
Suppose that a manager must decide whether to invest $500 million for a manufacturing facility which can be built today or at some later time. If the present value of cash flows from the facility is estimated at $500.001 million, NPV is $1000; hence by the NPV criterion the investment should be undertaken. Finance students often find the decision to invest $500 million in order to earn $1000 troubling, though they are often unable to articulate a reason. This lack of comfort may extend to managers: it appears common for firms to use investment criteria which do not strictly implement the NPV criterion.
Anecdotal evidence suggests that firms making capital budgeting decisions routinely do a number of things that basic finance textbooks say they should not do:
projects are taken based on whether or not internal rates of return exceed arbitrarily high discount rates (often called “hurdle rates”),
hurdle rates are sometimes higher for projects with greater idiosyncratic risk,
project selection is sometimes governed by a “profitability index”, i.e., NPV/(Investment Cost) must be sufficiently great, and
otherwise acceptable projects go untaken, i.e., firms engage in capital rationing.
This article asks whether these seemingly “incorrect” capital budgeting practices might serve as proxies for economic considerations not properly accounted for by the NPV rule. It is well-known by now that the NPV criterion has serious shortcomings. In particular, the project in the example above could be delayed. Under uncertainty, the decision about when to invest is analogous to the decision about when to exercise an American call option, and the firm should generally invest only when the project NPV is sufficiently positive. Obviously, most managers do not formally perform this calculation as a routine part of capital budgeting.1 Nevertheless, although managers may not use formal models to evaluate the options associated with an investment project, these options can be economically important and their effects grasped intuitively. Firms that make decisions ignoring these options should on average be less profitable than firms that somehow take them into account. This raises the question: is it possible that firms can make investment decisions that are close to optimal by following simple rules of thumb? Summers (1987) surveyed corporations on capital budgeting practices and found that 94% of reporting firms discounted all cash flows at the same rate, independently of risk; 23% used discount rates in excess of 19%. This behavior is suggestive of the use of hurdle-rate rules, and certainly at odds with textbook prescriptions for how to do capital budgeting.
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Real Options and Rules of Thumb in Capital Budgeting
