by Tom Copeland and Peter Tufano
T' HE MARKET VALUES a growth Company largely by
estimating the prospects of its portfolio of growth
projects. These projects-research and development,
investments in new capacity, geographical expansion, and
other initiatives-are seldom simple onetime decisions;
in most cases, a company's investments are multistaged,
and at each step the company may push ahead or pull out
after gaining new information. These projects are thus options-"
rear' options, as opposed to financial options-in
which managers have the right but not the obligation to
invest. It's therefore appropriate that managers have begun
to apply option theory to help them make decisions
about these projects. Indeed, a survey of 4,000 CFOs published
in 2001 by John Graham and Campbell Harvey
found that 27% of the respondents claimed they "always
or almost always" used some sort of options approach to
evaluating and deciding upon growth opportunities.
But there are, it seems, at least as many customers who
are dissatisfied with this tool. Also in 2001, a "Management
Tools and Techniques" survey by Bain & Company
of 451 senior executives who had tried the real-options
approach showed that fully a third of them had given up
using it that same year. The reasons for this high defection
rate seem just as sensible as the reasons for using the tool
and are usually based on technical grounds. As many
executives point out, options embedded in management
decisions are far more complex and ambiguous than
financial options. Their concern is that it would be dangerous
to try to reduce those complexities into standard
option models, such as the Black-Scholes-Merton model,
which have only five or six variables. What's more, in the
wake ofthe high-tech collapse, it's easy to see why people
might be skeptical of a valuation tool that arguably exaggerated
those companies' growth potential.
Critics are right to point out problems witb tbe... [continues]
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