A cure for outdated capital budgeting techniques

Cotter, James Finn; Marcum, Bill; Martin, Dale R.

doi:10.1002/jcaf.10154

Cited by 5 publications

(7 citation statements)

References 6 publications

Supporting

Mentioning

Contrasting

Order By: Relevance

“…The results are surprising considering the recent and extensive coverage of real options in the literature. Reasons for not using real options include scepticism, complex and cumbersome techniques, lack of management support, DCF being considered a proven method, and real options too risky (Block, 2007; Cotter et al , 2003).…”

Section: Resultsmentioning

confidence: 99%

Improved capital budgeting decision making: evidence from Canada

Bennouna¹,

Meredith

Marchant

2010

Management Decision

133

114

View full text Add to dashboard Cite

Purpose -The purpose of this article is to evaluate current techniques in capital budget decision making in Canada, including real options, and to integrate the results with similar previous studies. Design/methodology/approach -A mail survey was conducted, which included 88 large firms in Canada.Findings -Trends towards sophisticated techniques have continued; however, even in large firms, 17 percent did not use discounted cash flow (DCF). Of those which did, the majority favoured net present value (NPV) and internal rate of return (IRR). Overall between one in ten to one in three were not correctly applying certain aspects of DCF. Only 8 percent used real options. Research limitations/implications -One limitation is that the survey does not indicate why managers continue using less advanced capital budgeting decision techniques. A second is that choice of population may bias results to large firms in Canada. Practical implications -The main area for management focus is real options. Other areas for improvement are administrative procedures, using the weighted average cost of capital (WACC), adjusting the WACC for different projects or divisions, employing target or market values for weights, and not including interest expenses in project cash flows. A small proportion of managers also need to start using DCF. Originality/value -The evaluation shows there still remains a theory-practice gap in the detailed elements of DCF capital budgeting decision techniques, and in real options. Further, it is valuable to take stock of a concept that has been developed over a number of years. What this paper offers is a fine-grained analysis of investment decision making, a synthesis and integration of several studies on DCF where new comparisons are made, advice to managers and thus opportunities to improve investment decision making.

show abstract

Section: Resultsmentioning

confidence: 99%

Improved capital budgeting decision making: evidence from Canada

Bennouna¹,

Meredith

Marchant

2010

Management Decision

133

114

View full text Add to dashboard Cite

show abstract

“…Lack of management support (Cotter et al, 2003) Chapter 7 discussed in detail how a top-bottom approach support from management can improve the acceptance, adoption and implementation of ROA in the mineral industry.…”

Section: Critique Of Adopted Approachmentioning

confidence: 99%

“…Chief among them are: scepticism, complex and cumbersome techniques, lack of management support, the DCF being considered a proven method and ROV considered a risky method (Block, 2007;Cotter et al, 2003). Practically, one major weakness that has hampered the implementation of real options in several projects has been the application, of a single variable, in most cases the commodity price, as the only source of uncertainty in mineral project valuations (Samis et al, 2005;Blais et al, 2007; to prove similarities with financial options (Davis, 1996).…”

Section: Methodsmentioning

confidence: 99%

“…Block (2007) observed in his survey that 31.7% of the respondents attributed their lack of interest in real options to the sophistication in the models as well as the risky nature of the assumptions used. Cotter et al (2003) also identified implausible mathematical assumptions as the major hindrance in the adoption of real options in capital budgeting decision-making. Auger and Guzmn (2010) opine that real options is popular in academia but unsuccessful in terms of application in the mineral industry with no mining company making investment decisions based on real options.…”

Section: Background To the Researchmentioning

confidence: 99%

“…SRO follows Cotter et al (2003), to categorize real options flexibility into four groups with practical examples outlined in Table 5.3:…”

Section: Incorporating Flexibility In Adinkra's Valuationmentioning

confidence: 99%

See 2 more Smart Citations

Reasons why Real Options Analysis (ROA) is not widely adopted in the mineral industry

Ampofo¹

View full text Add to dashboard Cite

Real options analysis (ROA) is an advanced technique for valuing mineral projects that generates more useful information for decision-makers in the mining industry than that generated using discounted cash flow (DCF) method, yet the latter is much more commonly used in the industry. Why?The answer to this question motivates the thesis.The slow adoption of ROA in the mineral industry has been investigated by several researchers.The outcomes of these previous studies have had minimal impact on the industry because these researchers adopted an approach that focused solely on the quantitative shortcomings of ROA. Until now, little empirical evidence existed on the qualitative reasons that impede the mainstream adoption of ROA as a valuation technique in the mineral industry in spite of its well-established advantages.This thesis advances a series of innovative solutions to address this gap. First, it develops a novel system approach to ROA based on practical assumptions. Secondly, it applies this system approach to a real mine case study to identify the value-added information generated by the ROA method compared with the DCF method. Finally, based on the case study output, the study engages industry experts to identify the qualitative reasons for the relatively low uptake of ROA in the mining industry.In developing the novel system approach to applying ROA, the study focused on building a framework that incorporates realistic modelling of project uncertainties, careful modelling of the value of mineral assets and development of a user-friendly end-user tool that simplifies the process. The system real options (SRO) tool was developed using Matlab to estimate the economic value of projects using ROA. SRO reduces the complexity in ROA application and integrates the method with Monte Carlo simulation and statistical distributions to enable mineral projects under uncertainty to be realistically valued and optimised.To identify the additional information that ROA generates over the DCF method in mineral project valuation, SRO was used to re-value a gold mining project, Adinkra Mine, initially valued using the DCF method in 2004. The initial DCF method valued the project at $493 million; however, SRO recorded a $528 million mean project value with a 62% probability of the project returning a higher value than the DCF value. In addition, the value of the option to expand the mine's capacity was i analysed using the SRO tool to guide the company in its strategic decision-making. Subsequently, the company's country expansion program was assessed using SRO to determine the value of each project under different in-country scenarios. The results of the DCF and ROA were statistically compared with the actual (real) project outputs from 2004 to 2015. The results indicated a higher correlation between the actual (real) project outputs recorded from 2004 to 2015 and the valuation results recorded using the ROA method. In addition, using the ROA approach enabled useful information to be generated that showed significant pot...

show abstract

Capital budgeting practices in Indian companies

Batra

Verma²

2017

IIMB Management Review

View full text Add to dashboard Cite

A cure for outdated capital budgeting techniques

Cited by 5 publications

References 6 publications

Improved capital budgeting decision making: evidence from Canada

Improved capital budgeting decision making: evidence from Canada

Reasons why Real Options Analysis (ROA) is not widely adopted in the mineral industry

Capital budgeting practices in Indian companies

Contact Info

Product

Resources

About