There are more sources of value in investments, capital expenditures or acquisitions than expected through conventional Discounted Cash Flow (DCF) and Net Present Value (NPV) analyses. Conventional DCF and NPV analyses underestimate these sources when the decision to either invest or not invest can be deferred. For example, if there's an outcome in the realm of possibilities that a future investment decision in your business could be better off by waiting for developments to materialize, then, conventional DCF and NPV analyses would fall short.

According to Timothy A. Luehrman [See Note 1] from Harvard Business Review (HBR) in issue July - August, Y1998, the two main reasons for the missing sources are because of the following:

1.) "We would always rather pay later than sooner, all else being equal, because we can earn the time value of money on the deferred expenditure."

2.) "While we’re waiting, the world can change. Specifically, the value of operating assets we intend to acquire may change. If [operating assets] value goes up, we haven’t missed out; we still can acquire [these operating assets] simply by making the investment [and] exercising our option. If [operating assets] value goes down, we might decide not to acquire [these operating assets]. That also is fine -- very good, in fact -- because, by waiting, we avoid making what would have turned out to be a poor investment. We have preserved the ability to participate in good outcomes and insulated ourselves [by the mitigating the risk] from some bad ones."

In general, if there's managerial flexibility before a decision, then, there's value. Financially (or, in a general sense, economically), this is known as options value (or real options value) -- and, therefore, to defer an investment decision has value. "Traditional NPV misses [this] extra value associated with deferral because it assumes the decision cannot be put off [or called up later]." On the other hand, options value inherently presumes the manager's, owner's, capital allocator's, or entrepreneur's ability to defer -- and, consequently, provides a way to quantify the value of deferring the investment decision in scope.

For these two sources of value, there are two new metrics that would supplement the traditional NPV calculation. I'll explain the steps from the HBR article on how to capture this value in my next post. The next post will show how cash flow projections and NPV calculations for a proposed investment to expand manufacturing operations starting three years out would have been valued at -$53 million, e.g., a do-not-invest decision as NPV would be less than zero. However, the next post will show how the same expansion over the same time horizon would be valued at $48.6 million using real options analysis (ROA), instead [See Note 2].

Note 1. Investment Opportunities as Real Options: Getting Started on the Numbers by Timothy A. Luehrman. From the Magazine (July–August 1998)

Note 2. ROA is not a way to over-inflate the value of projects and, thus, fund bad projects. It can be shown that the limiting case for real options value is NPV. An entrepreneur would not have any flexibility when there's not any time remaining to put off the decision. The entrepreneur would be correct to just accept the NPV calculation in this case.