Valuation, 7th Edition

39Flexibility

Properly managing a modern business is about making choices to create value. Valuation provides important insights for executives faced with making decisions on corporate strategy, acquisitions and divestments, capital structure, and other management actions. All these decisions take place against a backdrop of uncertainty about the outcomes of alternative courses of action.¹ However, in some cases, you can face decisions where not only is uncertainty present, but so is flexibility.

Managerial flexibility and uncertainty are not the same. In cases of uncertainty, the future of a company or a project may be extremely difficult to predict and depends on a single management decision—for example, to launch a new product line or to invest in a new production facility. Flexibility, in contrast, refers to choices managers may make between alternative plans in response to events. This is especially true when you are conducting valuations of investment projects.

The difference is important in deciding your approach to valuation. Whatever the degree of uncertainty, it is possible to value the asset in question by using a standard discounted-cash-flow (DCF) approach combined with either different scenarios or a stochastic simulation (see, for example, Chapter 17). But suppose management has planned to stage its investments in a business start-up. In that case, the managers may decide at each stage whether to proceed, depending on information arising from the previous stage. ...