In Practice Are strategic considerations really options

Many firms, faced with projects that do not meet their financial benchmarks, use the argument that these projects should be taken anyway because of "strategic considerations". In other words, it is argued that these projects will accomplish other goals for the firm or allow the firm to enter into other markets. While we are leery of how this argument is used to justify poor projects, there are cases where these strategic considerations are really referring to options embedded in projects - options to produce new products or expand into new markets.

Take the example of the Disney Channel project described above. The project, based upon conventional capital budgeting, has a negative net present value, but it should be taken nevertheless, because it gives Disney the option to enter a potentially lucrative market. Disney might well use the "strategic considerations" argument to take the project anyway.

The differences between using option pricing and the "strategic considerations" argument are the following:

1. Option pricing assigns value to only some of the "strategic considerations" that firms may have. For instance, the option to enter the Latin American market has value because of the variance in the estimates of the value of entering the market, and the fact that Disney has to take the smaller project (the Mexican venture) first in order to get the option. However, strategic considerations that are not clearly defined or include generic terms such as "corporate image" or "growth potential" may not have any value from an option pricing standpoint.

2. Option pricing attempts to put a dollar value on the "strategic consideration" being valued. As a consequence, the existence of strategic considerations does not guarantee that the project will be taken. In the Disney example, the Mexican venture should not be taken if the value of the option to enter the Latin American market is less than $ 20 million.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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