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Research on Improvement to Capital Budgeting Methods Based on Real Options

Author: QiuYing
Tutor: LiJingMing
School: Wuhan University of Science and Technology
Course: Accounting
Keywords: Real Options Capital Budgeting Discount Cash Flow Method (DCF) Physical Asset Management (PAM)
CLC: F830.42
Type: Master's thesis
Year: 2013
Downloads: 28
Quote: 0
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Abstract

Actually the executives are required to make reasonable and effective long-term capitalinvestment decisions so as to create possible values, considering the object of maximizing theenterprise value. Relatively, it is an important method for the enterprises to realize the long-termcapital investment objectives by choosing proper capital budgeting methods, and then the freecash flow model as one of important traditional capital budgeting methods is shaped. However,the subjective option made by the management based on the uncertain conditions as well as theopportunity value existed in the investment project (option value) are neglected by the traditionalcapital budgeting methods, which leads to the inconsistent results with the facts. Therefore, howto improve the traditional capital budgeting methods from the perspective of real option has beenpaid much attention to by the current finance field. Then, the paper put forward therecommendation to combine the free cash flow model with real option pricing method, whichcould evaluate the capital budgeting project competently. Moreover, the significant advice onimproving the traditional budgeting methods is showed eventually.From the perspective of the finance and economics, initially, the paper makes a series ofdemonstrations on the traditional free cash flow model as well as its process, and then it makesome analyses on the real option pricing method as well as its application in the practice. In thisway the conception that could be significant for the executives to introduce the real optionpricing method to capital investment and to be applied to the physical assets management. Inaddition, the way on how to improve the system on traditional capital budgeting based on thereal option will be illustrated, including the respective processes of the whole improved capitalinvestment decision methods. Finally, the improved capital budgeting methods will be tested byboth A company and B company, putting forward reasonable conclusions and usefulrecommendations eventually.There are six chapters totally in the paper, analyzing the traditional capital method focusedon the real option. First of all, in the first chapter, the relevant background and purpose on thecapital budgeting are introduced, analyzing the existing literature on home and board as well asdemonstrating the main research methods applied in the paper. In addition, the second chaptermakes a detailed analysis on the cash flow model and relevant traditional capital investmentmethods, including the contents and theoretical basis; and the third chapter introduce the realoption from the perspective of finance, reflecting the reasons that combines cash flow modelwith the real option pricing models. Then, the forth chapter demonstrates the two differentimproved capital budgeting methods respectively. On the basis on the former chapter, the casestudy on A company and B company are carried out to prove the practical value in assessing thecapital investment. Finally, the final chapter sums up the ideas and methods on the capitalinvestment decision, putting forward new prospects and requirements on the future system ofcapital budgeting methods.

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