Managerial judgement and the real options approach in investment appraisal process: evidence from the British automotive components manufacturers.

Abstract

While there has been extensive research on the use of financial appraisal techniques (Pay back, Return on Capital Employed, Internal Rate of Return and Net Present Value) in the Investment Appraisal Process (lAP), little research has been conducted on the role of the Real Options Approach (ROA) and Managerial Judgement (MJ) in the IAP. In an ideal world, prior to making Strategic Investment Decisions (SIDs), a detailed analysis of the benefits generated by the investments would be conducted. This would cover financial and nonfinancial benefits. In practice, however, many investments are undertaken on the basis of financial returns with little or no analysis of the growth options embedded in the proposed investments. The exploitation of these options contributes to the enhancement of the business strategy as financial returns do. Essential to considering these options in the IAP is the deployment ofMJ inthe lAP. This thesis aims to make a sound contribution to the development of the emerging literature on capital budgeting. First, it provides a critical review of the existing investment appraisal literature. Second, it investigates whether or not British Automotive Components Manufacturers (BACMs) deploy the ROA and MJ in the lAP in order to accommodate the growth options. And fmally, it presents an alternative perspective of the IAP by the development of a conceptual framework that integrates the ROA & MJ into the lAP, while taking account ofproject risk and business strategy. This research draws on a 73-firm survey of finance directors in this industry enhanced by fieldwork (11 interviews) to set out the relative importance of the strategic approach (ROA informed by MJ) and financial analysis when making the SIDs. The findings from the survey show similar results to earlier studies in relation to the popularity of PB and the use of more than one financial technique in the lAP. However, in contrast to previous studies, DCF techniques seem to be less popular and higher usage of ROCE is evident, and no relationship is found between company size and the range and type of techniques used in the lAP. The main thrust of the findings of the statistical analysis is the absence of the formal adoption of the ROA in the IAP. However, the impact of the growth options regarding the deployment of MJ in the lAP appeared to be evident. The analysis shows that MJ is considered when assessing both investments with growth options and risky projects. The fieldwork provides insights into the context of the lAP and the factors that influence the deployment of the ROA and MJ in the lAP. Conclusions are drawn regarding the interrelationships between financial analysis and the ROA and MJ in the lAP. The integration of the ROA and MJ into the lAP appears to involve moving the focus of attention in the lAP away from financial analysis and a short-term perspective towards a more strategic perspective. More importantly, it contributes to bridging the gap between risk management and strategic analysis.