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Article Excerpt
The process of evaluating the desirability of long-term investment proposals is referred to as "capital budgeting." Making optimum capital budgeting decisions (e.g., whether to accept or reject a proposed project), often requires recognizing and correctly accounting for flexibilities associated with the project. Such flexibilities are more formally termed real options. (1) From a valuation standpoint, these options are valuable because they allow decision makers to react to favorable or unfavorable new situations by dynamically adjusting the capital budgeting decision process. Unfortunately, the value of real options is not explicitly considered in conventional procedures (such as discounted cash flow (DCF) models) used to evaluate long-term investment proposals. In some sense, therefore, real options can be viewed as an extension of DCF that incorporates a simple model of strategic learning. (2)
In this article we present a short tutorial regarding real options--what they are and how they can be formally incorporated into the capital budgeting process. We also illustrate how to price a capital investment project containing real options. To explain these concepts to a wide audience in accounting, we take more of an intuitive approach and therefore abstract from more technical treatments of the topic, such as those explicitly linked to the Black-Scholes pricing model for financial options. (3) To illustrate basic concepts regarding real options, we use a straightforward example that relates to a rental car company that is considering whether to purchase a conventional gasoline-powered car or a hybrid car as an addition to its rental fleet, a decision complicated by uncertainties regarding tax incentives for commercial purchases of hybrid vehicles.
INCOME-TAX INCENTIVES REGARDING THE PURCHASE OF HYBRID VEHICLES
In 2002, Congress instituted a $2,000 income-tax credit for the purchase of a new hybrid vehicle, but, according to the proposal by Congress in late 2003, that tax incentive was to have been phased out entirely by 2007. Specifically, the $2,000 tax credit would be cut by 25% in 2004, 50% in 2005, and 75% in 2006. In late 2004, however, Congress reenacted the $2,000 tax credit for hybrid cars purchased in 2004 and 2005. In 2006, Congress passed a new bill that allowed a maximum tax credit of more than $3,000 for hybrid car purchases, but the determination of which hybrid vehicles qualified for the credit and the amount of credit to be taken was based on a complicated set of rules.
We use the preceding historical review to illustrate one type of cash-flow uncertainty associated with long-term investments in depreciable assets: income-tax consequences. As illustrated, tax effects on such investments are subject to the whim of Congress. Suppose that, at the present (say the beginning of 2008), Congress is debating a bill that would give commercial owners a tax break for purchasing (and using) hybrid vehicles. Assume, however, that passage of the bill is uncertain and that our rental car company is currently considering whether to add a hybrid vehicle or a gas-powered vehicle to its rental fleet. Uncertainties regarding income-tax provisions in the new energy bill complicate the analysis of this capital budgeting decision. One of the advantages of real options is the ability to deal explicitly with these and other uncertainties.
For simplicity, we make a few additional assumptions regarding this investment decision. First, we assume that the company plans to keep either car for four years, after which time the car will be sold for an estimated salvage value. Second, if the new energy bill is passed, we assume that the income-tax credit for operating commercial hybrid vehicles will start one year hence, that is, in January 2009. Management believes there is a 40% chance that the bill will be passed and that the final fate of the bill will be known by January 2009. Third, if the bill is passed, the annual after-tax cash flow from operating the hybrid car is estimated to be $10,000; assume, too, a net-of-tax salvage value of $5,000 for the hybrid car at the end of year four. If the bill is not passed, the annual after-tax cash flow for the hybrid car drops to $4,000, and its net-of-tax salvage value at the end of year four would be $3,000.
For the gas-powered vehicle, assume that...
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