In valuing companies with the standard discounted cash flow (DCF) approaches outlined in Part Two, we did not consider the value of managerial flexibility. Managers react to changes in the economic environment by adjusting their plans and strategies. For example, they may choose to scale back or abandon an investment project that delivers poor results, or to expand or extend the project if it is highly successful. Such flexible changes of plan can take many different forms, and each may have a substantial impact on value. A standard DCF approach based on a single cash flow projection, or even multiple cash flow scenarios, cannot calculate what that impact is.
Managerial flexibility is not the same as uncertainty. Companies or projects with highly uncertain futures involving a single management decision, such as business start-ups with high growth potential, can indeed be valued using a standard DCF approach under different scenarios (see, for example, Chapter 34). Flexibility refers to choices between alternative plans that managers may make in response to events. For example, if they have planned to stage their investments in the business start-up, they may decide whether to proceed or not at each stage, depending on information arising from the stage before. For cases where managers expect to respond flexibly to events, we need a special, contingent valuation approach.
Company-wide valuation models rarely take flexibility into account. To analyze and model ...