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BIOGRAPHYMario Luis Perossa is Masters in Finance from National University of Rosario, Accountant and Bachelor in Business Administration from the University of Buenos Aires. Professor at the University Maimonides Financial Management Course. He can be reached at the Department of Finance Research, CEJU of Maimonides University, Hidalgo Street 750, Buenos Aires.
Elena Alejandra Marinaro is Masters in Business Administration from the Universidad del Salvador and the University of Deusto, Accountant from the University of Salvador. Academic Secretary and Director of the International School of Business at the University Maimonides. She can be contacted at the School of International Business at the University Maimonides, Hidalgo Street 750, Buenos Aires.
GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 167 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1
PROSPECTS OF REAL OPTIONS USE IN INVESTMENT
PROJECT VALUATION IN BANKSKhaliun Ganbat, Plekhanov Russian University of Economics
This article discusses the necessity of bank managers to evaluate investment projects with real options. The object of study is the investment activity of banks, and the subject is optimization of investment projects valuation method in the framework of banks risk management. The main objective of the study is to develop an optimal methodology for the investment project valuation that will enable the effective management of bank funds and obtain sufficient investment income. While studying the problem, there were set following tasks to solve: Analyze investment project valuation methods and ways of their optimization; Identify opportunities of using real options in the valuation of investment projects in bank; Make own conclusions on the studied subject. The relevance of the chosen topic is determined by the necessity of optimal risk management tools and definitions in assessment methods of the investment project. The use of real options is one of the innovative approaches to the valuation of assets. Traditional methods of valuating investment projects are not taken into account when calculating the competitive advantage and flexibility in management. Moreover, bank managers face the uncertainty at the beginning and in further development of the project that forces managers to use more flexible tools for assessing the investment project. As the result of this topics study there arises a question to consider for the heads of the bank about including real option method in its activity. The use of this method is one of the innovative methods in evaluating investment projects and will let managers of the bank to be more flexible.
JEL: G00 KEYWORDS: Investment project, investment project valuation, real option, banks, risk-management.
The investment activity of commercial banks, along with its classic operations, such as loans, plays a significant role in the formation of bank assets. These operations are aimed at the formation of the trading portfolio in order to obtain speculative and investment income, investments in securities and shares of organizations for the purpose of joint commercial activities as well as investing in the project, which is significantly important area for the success of the bank.
At the present time methods of valuation of investment projects in banks are limited. The market is characterized by high uncertainty, which leads to the importance of qualified evaluation. Therefore, there is need to expand the system of assessment methods that would reduce the risk of loss of funds for the bank and for the companies that are the creators of the project. These tools include real options method, which was proposed by a number of foreign authors in the mid-1980s, which began to put into practice since 1990s (Mostly in oil and mining companies.) The main feature of this method is the fact that it fits into a rapidly changing economic environment. In Russia, for example, there are not many authors who do a research about this method, and especially its application in banks. The monograph of Russian economist Gusev A. A., which was released in 2009 considering the full range of real options in valuation of business and investment based on the number of foreign authors . In this work he shows the necessity and importance of real option method for the company, but didn’t pay attention on its application in banks.
There were numerous articles published by authors such as Abramov G. F., Bulgakov L.G., Grishina S. A., from which it’s clear that Russia, for example, has an increasing interest in this issue every year, although the degree of scrutiny is rather small. Abramov G. F. gave the definition of real option in his article, its difference from a financial option and the method of investment projects evaluation with real options. While Bulgakov L. G. studied the possibility of banks participation in financing investment projects. Comparative GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 168 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 analysis between the traditional method of project appraisal and real options method held in the work of Grishina S. A., but it does not show possible applications, in particular in banks . Thus, the extent of studying this topic is relatively small and the application of real option method is not used in the banks investment project evaluation.
projects. Traditional methods of evaluation of investment projects, based on discounted cash flows, which
have some disadvantages:
Assume that managers decisions immutable;
Do not consider the possibility of changes in managers decision in several periods of time;
Do not count the period in which the investment opportunity is retained; the uncertainty of future cash flows, the yield of securities; the cost depreciation during the term of the option.
But the use of real options can solve the problems above. This method is an alternative view of the investment analysis and projects evaluation in the present economic condition.
Figure. 1. A comparative illustration of the factors considered in the NPV (net present value) and the value of real option 
Traditional approaches of project evaluation are based on the applicable accounting approach and a stable market situation, but in today's fast-growing market with a high degree of uncertainty it is preferable to use real options. Generally real option gives the right but not the obligation, to its owner to commit various types of management decisions in the future. If a financial option is usually the right to purchase/sale of financial assets, such as stocks, bonds and to hedge financial risks, the real options allow you to change the course of the project and to insure against strategic risks.
GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 169 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 Although, there are two different methods NPV and real options, these methods are not isolated from each other. On the contrary, the practical application of the theory of real options based on traditional instruments of discounted cash flows and they are used in more effective assessment of the investment.
In general, main risks of financing investment projects are (Risks that are specific for the project):
Market risk, which is defined as the risk of shortfall in the planned profit due to low sales and prices of goods. The main reasons are the rejection of a new product by the market or just too optimistic assessment of sales due to incorrect valuation of the competitiveness of goods and misuse of pricing. Moreover there may be errors in positioning and product promotion policy, in other words the wrong way of promotion can lead to this kind of risk;
The risk of exceeding the project budget and non-compliance with schedule, which leads to an increase in payback period of the project. The causes of this risk can be objective, such as changes in legislation and be subjective, which is associated with a lack of study and work on the inconsistency of the project;
General economic risks, including all external risks affecting the project and the bank, such as currency risk and interest rate risk, increase or decrease in inflation and the risk of increased competition in the industry .
The main advantage of the project evaluation with real options is that it accounts the degree of uncertainty and the retention period of investment opportunities, as well as reducing these risks and provides an opportunity to change the course of the project upon the occurrence of general economic risks.
The following example shows the effect of uncertainty on the value of option.
Bank A invests in a completely new project of organic products production and create the possibility of release after 2 years. If competition in the market will increase by the time of the investment, the rate of NPV (net present value) of the draft can become negative (Meaning that cash flow may decline from the planned value.) And then there is a dispute about whether to continue to invest, if increased competition
Where Ct - the expected cash flow for the period of time t;
k - the discount rate based on risk.
For example, the expected probability of NPV = 5 million USD is 0.5 and the expected probability that NPV = - 5 million USD is also 0.5.
Hence, the average weighted NPV = (5 × 0.5) + (0.5 × (-5)) = 0.
At this stage Bank stops its investment and the project is over. But this decision is not correct, because it does not take into account the fact of the possibility of project management choice. For example, if the projected NPV becomes negative, the management may refuse financing the project and reduce the NPV to zero.
0.5 × 5 + 0.5 × 0 = 2.5 million.
Obviously, the choice has certain cost. In this case, the expected value of real option will be 2.5 million dollars. The correct solution to this situation would be a continuation of investments in the project as long as the total amount does not exceed $ 5 million.