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The Research on Evaluation and Decision-making of Venture Capital Project Based on Real Option Theory

Author: HanXia
Tutor: ZhouLi
School: Beijing Technology and Business University
Course: Finance
Keywords: Venture Capital Management Flexibility Real Options Project Evaluation
CLC: F224
Type: Master's thesis
Year: 2010
Downloads: 151
Quote: 0
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Abstract

Venture capital is a new pattern of financing system.which not only supplies the new economic increasing point but also promotes thansform high-tech achievement into products. Over the recent years, China’s venture capital has developed very quickly.Venture capital investment firms have also been increasing in number.Most of venture capital firms are high-tech enterprises which are typically highly risky, simutanioursly accompanied by high returns. It’s very vital for venture capitalists to choose the project with great potential profit to invest; however, there are few adequate assessment system and methods in the evaluation field. It is very difficult to assess with the traditional method which is so backward, as a result, to heavily hamper the development of our venture investment industry.Traditionally the economic value of a project is based on a discounted cash flow(DCF)analysis of point estimates of project incomes and costs.NPV has limitations as decision criterion for investments under uncertainty.Management accounting and corporate finance academics have reasoned that the conventional discounted cash flow techniques do not adequately capture the value of managerial flexibility to respond to risks and uncertainty in investment and operating decisions. And it often leads to the wrong investment decision. Previous research (e.g. Dixit and Pindyck, 1994; Trigeorgis, 1995) has demonstrated that this approach fails to capture the value of flexibility in project strategies and therefore can undervalue projects. Project value can be more accurately estimated by adding the value of flexibility.To overcome the above mentioned disadvantages of the current DCF methodologies, the objectives of this study are to develop a framework, namely the Real Option framework to address the uncertainty problems.The insight from real options is that a business investment opportunity can be conceptually compared to financial option.Within real investments, i.e., managerial flexibility "an irreversible investment opportunity is much like a financial call option" (Pindyck, 1991). In other words, real option valuation is treating investment opportunities and the different types of managerial flexibility as options and valuing them with option valuation models. Real options are useful both, as a mental model for strategic and operational decision-making, and as a valuation and numerical analysis tool. The problem of the impacts of project management quality on the value of flexible strategies is widespread because project managers commonly use many forms of flexibility that can be structured as real options. Real options techniques value managers’options to shelter investments from adverse effects and exploit upside potential. When investments provide the flexibility to expand, contract, delay and learn, management decisions can create value. A firm that uses real options thinking and models takes an active risk management view.A shift in valuation paradigms from a passive NPV to active risk management.The real option technique is a better decision tool when making decisions under uncertainty.To reduce the degree of information asymmetry,the venture capitalists usually conduct multi-stages investments.Therefore in this paper we concentrate on multi-stage investment opportunities as compound real options.Compound real options are combinations of real options, where an exercise of a real option opens another real option.In other words, Compound real options are possibilities that open new possibilities, i.e., a chain of contingent possibilitiesThis paper aims to construct a more scientific framework and by applying it to real case we introduce the new way of thinking to the venture investment decision making.

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