Entrepreneurs do not spend too much time planning, but often consider opportunities arising from uncertain conditions as they deal with original ideas. As new opportunities come into focus original ideas can garner new value not considered when the entrepreneur acted on an original opportunity.
Larger companies use net present value, internal rate of return, payback period, and many other sophisticated methods to evaluate cash streams from capital investments. Often these companies do not consider the “real options.” Capital budgeting involves understanding time value of money and probability analysis, which many entrepreneurs may not have learned about. The idea involves evaluating projects like a game of chance using the time value of money and probability analysis.
For example, the idea is similar to a card game in a casino and playing the odds. The player finding the project with the best odds usually wins. The concept of “real options” evaluates cash flow using net present value and the odds for each alternative to decide if the project has future value. If the expected value in a project turns negative the player can cut bait to minimize losses. On the other hand, continued investing may give the player an option to chase a project with a dubious future value.
Sometimes early losses can reverse and turn profitable. Without committing to an investment in a project, the entrepreneur may not see any prospect for net present value turning positive and not invest in the project. Thus the entrepreneur may find a project is worth investing in because the chances are good the net cash streams will turn positive sometime in the future.
“Real options” offer the entrepreneur a call option to help decide when to cut bait or to continue with a project. Without a sense of what lies ahead the entrepreneur may overlook good projects and exit too soon leaving the prize for someone else to discover.
What alternatives do you consider when deciding to invest in projects for your business?