|
V.R. (PERRY) PARTHASARATHY, PH.D., is principal consultant and DAN CENATEMPO is vice president and managing director for Jacobs-Sirrine Consultants, Atlanta, Ga.
|
In the pulp and paper industry, value creation has proved elusive for the last 30 years. In some part, this may be attributable to the use of the static net present value (NPV) rule as a financial tool for making capital investment decisions. While easy to understand, the rule often yields results that are overly optimistic. One of its major flaws is an unrealistic assumption that investment decisions are fully "reversible." Instead of considering the project as a portfolio of options with intrinsic value, NPV-based capital management considers the project as a "do it now or never" proposition.
One possible enhancement to NPV analysis is incorporation of the real option value (ROV) rule. Real option is a dynamic investment tool that captures the value of uncertainty in real world capital decisions. Although frequently used in emerging industries like information technology, its application in the capital investment decisions of a matured and cyclical industry like paper and forest products is still evolving.
LIMITATIONS OF THE NPV RULE. NPV is the present value of an asset minus the capital that would be required to acquire that asset. The NPV rule does have some significant problems. The first problem is the single point forecast used to predict future cash flows that is often overly optimistic in its projection. Managers often treat the forecasts as reality, creating an illusion of certainty about the numbers. To compensate, companies try to expand the analysis to a range of scenarios, and, though this seems rigorous, results are often opposite of what was forecasted. Therefore, the cash flow forecast becomes a subjective input rather than a quantitative estimation.
The second problem with the NPV rule is the forecasting tool used to determine the outcome of future investments. Managers tend to revise investment plans without correcting or modifying the underlying assumptions upon which the model is built. As the gap between the tool and the reality widens, the tools are discarded, and the multi-million dollar investments are made under the pretext of "strategic positioning."
The use of the NPV rule to fund capital projects has grown considerably during the past 25 years, and the pulp and paper industry has mostly used static NPV models based on discounted cash flow (DCF) to make its capital investment decisions.
One such example is the measure of economic value added (EVA), a registered trademark of Stern Stewart and Co., which has captivated the pulp and paper industry for quite some time. There are strong arguments, however, against using EVA as a single metric to evaluate project performance since it is calculated based on the DCF-NPV rule.
Since EVA is a measure of the cash flow generated over the cost of capital, it implies that investments should be made only in projects with positive NPV. EVA is excellent in calculating the free cash flow (on a cost adjusted basis) from a capital project and, as such, is a powerful tool to capture the total shareholder value.
However, although EVA is great for valuing a company's portfolio of current projects, it is truly deficient when it comes to valuing the portfolio of future options, because it says nothing about a company's readiness to capitalize on different contingencies.
During the last 20 years, the pulp and paper industry has lost close to $30 billion in EVA. In order to improve return on investment (ROI), the industry is trying to spend less capital than the annual depreciation of the asset. However, the very basis used for capital funding—the DCF-NPV calculation—is flawed, so any improvements in ROI would be, at the most, marginal.
Why do 87% of industries worldwide continue to apply the NPV rule to make strategic, as well as capital, decisions? Why do 100% of pulp and paper companies use the NPV rule to fund capital projects? For many non-financial managers who are the capital decision-makers for their corporations, the journey from financial options to actual investment decisions is difficult and deeply frustrating. That leads them to use more simple models, though they may be aware that these models are limited and conclusions from them may be incorrect.
REAL OPTIONS FOR A REAL WORLD. Advocates of real options are not looking to completely dispose of traditional NPV methods, but for the recognition that the NPV rule must be augmented with more strategic considerations that value the flexibility to execute projects. Application of ROV offers a new way of thinking about capital management.
What is a real option? An option is the right, but not the obligation, to take an action in the future. Options are exercised (used) only if the value of the asset exceeds a certain specified price. Therefore, flexibility to take action in the future has certain intrinsic value. The option-pricing model (OPM) captures that intrinsic value as an "option premium" and adds that to the NPV. In a narrower sense, real option is the extension of the financial option theory to real (non financial) assets.
The application of OPMs, in particular real options or ROV, to the capital decision-making processes of non-traded real assets seems somewhat restrictive and is relatively new in the world of corporate finance. However, it has been used in industries other than pulp and paper. Also, during the past two decades, a body of academic research on the application of OPM theory and methodologies to real assets has emerged.1,2 One assertion is that a more useful criterion should encompass both of the value components—the NPV of direct cash flows and the ROV of operating flexibility and strategic interactions.2 Combined, they provide a powerful capital management tool.
MANAGING CAPITAL IN UNCERTAIN TIMES. By their very nature, businesses are uncertain. Once a manager explicitly builds this uncertainty into his or her thinking, the whole decision-making framework changes. In this case, there is a value attached to the flexibility of waiting to invest.
With traditional thinking, high uncertainty involves huge risk that leads to lower asset value. However, with the real option approach, uncertainty has intrinsic value. The real option approach shows that increased uncertainty can lead to higher asset value if managers identify and use their options to respond to unfolding events with flexibility.3 The key to this is the link between time and uncertainty, since the value of an asset can go up or down in the future. For example, if the current value of an asset were $1 million, what would happen to its value in two years? Figure 1 shows two views of the possible value change of an asset during a two-year period.
|
Figure 1. Two views of an asset's possible value change during a two-year period
|
As the value of the asset changes over time, the highest and lowest values marked in Figure 1 are highly unlikely to occur. Figure 1b shows how the evolution of an uncertain variable over time is related to the distribution of outcomes at the end of the time horizon. It is likely that, in two years, the value of the asset will be near the middle of the range. The mean of the distribution provides the expected value in two years, and the standard deviation is a measure of the range of outcomes. During the two years, the asset's value will change at some rate. There is uncertainty about the actual growth rate, and this implies that the spread of the cone will be wider if the uncertainty is higher.
The flexibility afforded by real options modifies the investment exposure for uncertainty, as depicted in Figure 2. This is the classical difference between asset value assessment by traditional techniques and by the ROV technique. The real options approach interweaves the effects of time and uncertainty on valuation and decision-making so that it naturally focuses on volatility—the range of uncertainty about growth rates.
|
Figure 2. The ROV approach interweaves the effects of time and uncertainty on valuation and decision-making.
|
A PAPER MACHINE: TO BUILD OR NOT. Let us consider a hypothetical non-integrated mill. The mill purchases market pulp to manufacture xerographic 20-lb bond paper. The cost of pulp constitutes about 48% of the cash manufacturing cost of the finished product. The profit margin is therefore tied to both the pulp price and the sale price of the paper (Figure 3). The profitability depends on the spread between these prices, adjusted for the productivity. For the pulp and paper industry, historical data on the spread between the prices of the input (market pulp) and output (paper) suggest that it is mean reverting (Figure 3), which says that, in the long run, they tend to converge.
|
Figure 3. NPV analysis based on the spread between input (pulp) and output (paper) prices confirmed building a new paper machine, but the analysis did not consider market changes that could drop NPV.
|
Let us assume that the paper company described has decided to expend the capital to build a paper machine, but cannot commit to it outright. It has the option of staging the investment over 18 months: $10 million up front for the conceptualization and pre-engineering of the project, $25 million six months later for equipment contract commitment and pre-construction, and finally $200 million to complete the project. Even if the company paid out for the design stage, it can still walk away from the project without further investment if the new information available points to decreased profit projections due to changes in the market environment. In this case, the only loss is the $10 million spent on the conceptual phase, with the company saving $225 million of the total investment. Using the traditional NPV rule to evaluate the change in the profit scenario, the DCF-NPV for the project may be very small, but still positive enough to direct the company forward with the project and spending the full $235 million.
It is the general opinion among the industry watchers that investment in a new product line should be made only when the spread between the input and output is considerably higher than the long term average (Figure 3). In this case, a standard NPV analysis based on the current spread revealed that building the machine would have an NPV of $256 million, representing a value increase of $21 million. This suggests that the project should be undertaken, and the company should commit the full capital of $235 million.
However, if the market condition changes and the NPV drops to an insignificant but positive number, it is too late for the company to recoup the sunken cost since the investment is not staged. On the other hand, using ROV, with the embedded option to abandon the project after six months or a year, in addition to NPV, provides $310 million (a value increase of $75 million on the total project cost). This will be a bigger value if the project is staged and compared against the staged investment. This suggests that the company should in-vest in the design phase at the very least.
The NPV plus ROV approach also clarified the criteria for making decisions later; namely, the cut off values for the spread below which it would make sense to abandon the project. But why does the difference in the valuation between the NPV and the ROV (an OPM-based method) exist?
The problem with the standard NPV analysis is that it is too sensitive to the spread. The new product line costs about $235 million, and if the spread declines and the project is committed, the revenue shortfall will change the NPV value—sometimes to a negative NPV. On the other hand, if an option value is added to the NPV, either in embedded capacity or abandonment of the project, the flexibility to spend the money later when further information is available has certain intrinsic value. This flexibility can be bought by paying a small premium (option premium), which, in this case, is the pre-engineering expense that would be lost if the option was not exercised.
In other words, the NPV analysis assumes that the product line will be definitely built and operated, ignoring management's ability to walk away if revised projections make it advisable to do so. The ROV approach, on the other hand, recognizes management's power to put a "floor" under the losses and to not place a "cap" on the gains. Therefore, evaluating a project using the ROV rule, in addition to NPV, provides management a chance to cut its losses without forfeiting the gains.
REFERENCES
1. Dixit, A.K., "A New View of Investment" in Investment under Uncertainty. Eds. Avinash K. Dixit and Robert S. Pindyck. Princeton University Press. N.J., (1994).
2. Brennan, M., and Trigeorgis, L., "Project Flexibility, Agency, and Competition—New Developments in the Theory and Applications of Real Options." Oxford University Press, Oxford, U.K., (2000).
3. Amram, M., and Kulatilaka, N., in "Real Options—Managing Strategic Investment in an Uncertain World," Harvard Business School Press, Boston, Mass., (1999).
|
