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Capital Budgeting.

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Introduction

Essay 3 - Capital Budgeting Capital budgeting has received an increasing attention over the last ten years. Most studies have focused either on the relationships between investment decisions and financial theory, or on behavioural aspects of Capital Budgeting. The separation between analytical and organizational-behavioural aspects of budgeting, which has been criticized by many authors, appears particularly critical today: in fact, the implementation of new techniques in the analysis of investments - such as discounted cash flow modified methods, strategic options, scoring methods, analytic hierarchy process, fuzzy-logic approaches - requires an extremely accurate analysis that cannot be led only by the branch of the organization supporting the investment proposal, or by financial staffs, either. In this paper I will explore two methods (decision tree analysis and option methods) and examine how they can be used in capital budgeting. An effective and proactive strategic management of technology involves various decisions: from the formulation of a global technology plan to the selection and the adoption of a specific new asset. The basic question regarding the latter concerns which new technology has to be adopted and when. Time, in particular, is a crucial point, and deciding on the appropriate time is a critical issue which raises substantial questions coming from: the intrinsic uncertainty surrounding each new technology; the inherently intangible nature of many of the expected benefits; the long-term perspective involved by a technological commitment; the current and future availability of technical and economic information about the new technology; the need to develop new competences and skills; the role played by learning processes; the partial or complete irreversibility of the innovative investment. ...read more.

Middle

The relative importance of the three components - passive NPV, operating options and interaction effects - changes according to the conditions in which the firm acts. Certainly, the option value increases with the competitive dynamics and with the current or perspective firm's business opportunities. However, valuing these opportunities correctly is particularly complex and is further complicated by the co-existence of various kinds of options and the possible existence of options on options. With regard to the existence of joint effects between different options, it must be carefully noted that their quantification does not reduce to a simple arithmetic sum of the individual option values, since the single effects could be alternative or even annul each other. Bearing these difficulties in mind, but thinking it correct to refer to a consolidated approach, we will develop a procedure for deciding the adoption time of a new technology on the basis of this model but now let's examine decision tree method. Decision trees are designed to assist the decision maker with "longitudinal" decision making, where, for example, a decision may be made, some further events may occur, a subsequent decision may be necessary and yet more events may occur. They are a tool which should assist the decision maker when making an initial decision to consider the range of events and subsequent decisions that may occur or be necessary and should encourage the decision maker to think beyond the immediate decision. The series of events and decisions may occur in a relatively compressed period of time, or may be extended over a long period, of say, several years. Typically, then, decision trees may be used for forecasting. ...read more.

Conclusion

This can often provide a way forward when there is insufficient information, but it does offer a limited perspective. The application of different decision criteria in a decision tree will often suggest: * a different expected value at the first decision node; * the adoption of a different strategy. Finally, we have explored, using appropriate examples, the ways in which decision trees can be used by the manager to assist in the longitudinal decision-making process. Because of the mathematical concepts associated with complex decision trees, managers can be reluctant to attempt to use decision tree models. A recognition that such models can be simply developed in a spreadsheet environment, and can then be used for sensitivity analysis using different decision criteria, demonstrates that decision trees can offer valuable insights into the structure of a strategic decision problem. However, when the adoption of a new technology is considered, deciding on the appropriate time is an important strategic question. Time, in fact, can have a substantial influence on the competitive advantage offered by the innovation. In this paper we have examined the value of the adoption decision, thus proposing a technique for its timing. It is a four-step procedure which substantially stands on an option-based perspective and considers adoption, not of a single decision, but a process of continuous monitoring of the business and technical environment. The value of this approach is twofold. On the one hand, it stresses the importance of considering all the (present and future) advantages directly and indirectly involved with the new technology; on the other, it highlights the value of a persisting information-gathering activity. It is exactly in the direction of taking explicit advantage and continuously generating new opportunities that we have extended our reasoning, thus providing, from the suggested procedure, an option-based approach to technology strategy. ...read more.

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