RO-Based Capital Budgeting : A Dynamic Approach in New Economy

In today's business scenario, traditional measures of capital budgeting were no longer adequate to reflect the dynamic world of new economy. The current era is characterized by increased uncertainty and complexity because of changed market and economic conditions, M&A, globalization, integration of world financial market, increased competition, and the advent of new and emerging technologies. Typical approaches to project evaluation are based on Discounted Cash Flow (DCF)-based measures such as Net Present Value (NPV) and Internal Rate of Return (IRR). However, these demonstrate weaknesses in dealing with uncertainty, complexity, and flexibility. The techniques only use tangible factors and do not take into account intangible factors such as future competitive advantage, long-term growth opportunities, and managerial flexibility. This paper discusses the limitations of the traditional capital budgeting tools. Real Options (RO) approach is a method of evaluating and managing strategic investment decisions in an uncertain business environment. The RO approach seeks to uncover and quantify a project's embedded options. Firms in the fast-growing and ever-changing industries of the new economy require a dynamic approach like RO in investment decisions. This study also illustrates numeric example of RO. It discusses various approaches of using RO in adopting emerging technologies like Radio Frequency Identification (RFID). It also discusses various embedded options available for RFID deployment in supply chain management. Real option is an interdisciplinary subject, combining finance, strategy, and IT. RO analysis is a powerful financial tool that meshes well with the complexities of emerging technology projects that inherently carry significant uncertainty, but also represent great potential value for the firm. RO analysis is a very exciting development in the practice of capital budgeting. RO is a new economy tool and gives a better structured decision making process for complex and interdependent investment decisions of new economy. The study also explains the limitations of RO.