The major prerequisite of successful entrepreneurship venture is quality of decision-making process. Decision in investment is the most important financial decision. It is a part of both long-term business planning process and strategic business definition. Using available investment appraisal methods, entrepreneur should make positive or negative investment decision. Within the development of the economic theory and the practice many of methods made decision-making process rational and gave the scientific and practical base for successful project evaluation.Agricultural and Food Policy, Food Security and Poverty, Productivity Analysis,

Hadelan, Lari

English

Research Papers in Economics

Applied Studies inAgribusiness and Commerce – APSTRACT
Agroinform Publishing House, Budapest MBA DISSERTATION SUMMARIES
Investment analysis of plum brandy production –
methodology approach
Lari Hadelan
University of Zagreb Faculty of Agriculture
Executive MBA Training in Agribusiness and Commerce
Introduction
The major prerequisite of successful entrepreneurship
venture is quality of decision-making process. Decision in
investment is the most important financial decision. It is a
part of both long-term business planning process and
strategic business definition. Using available investment
appraisal methods, entrepreneur should make positive or
negative investment decision. Within the development of the
economic theory and the practice many of methods made
decision-making process rational and gave the scientific and
practical base for successful project evaluation.
In practice, there are three major traditional methods of
evaluating investment proposals:
• Payback period method (PP)
• Net present value method (NPV)
• Internal rate of return method (IRR)
The advantage of all these methods is, first of all,
simplicity and explicit interpretation of the results. However,
they have some imperfection, which can be overcome using
modern option approach.
All these three traditional methods use, as the base,
projected cash flow that is discounted according to the time
value of money.
The largest problem for each investment is uncertainty of
the future performance. Investors will never invest until
future major uncertainty is cleared. In other words, investors
have the opportunity or option but not the obligation to invest
in a project in a period of time. They can also have flexibility
to abandon, expand, contract, extend and shorten the
operation of the project even after the investment. A good
project evaluation methodology or model should incorporate
in a quantitative way all the three characteristics:
irreversibility, uncertainty and flexibility. Traditional
(conventional) appraisal methodologies for project
investment can hardly incorporate the three characteristics
above.
In recent years, management accounting and corporate
finance academics have reasoned that the conventional
discounted cash flow techniques do not adequately
incorporate the value of managerial flexibility to respond to
the changes that can emerged during the project’ s life
(Herath, Bremser, 2005). Furthermore, they do not take in a
count properly risks and uncertainty in investment and
operating decisions. An emerging method of research in
capital budgeting called real options has been developed to
overcome these limitations (Herath, Bremser, 2005).
Real options techniques value managers’options to make
some adjustments according to the current market situation.
Once projected business plan does not have to be eternal and
unchangeable. Each project can be expanded if circum-
stances enable it, it can be cancelled if market condition
become worse and it can be delayed for some better business
condition period.
Real option methods for investment appraisal includes
possible volatilities during the project life by identification of
all options that entrepreneur have and adding this option
value to the total project value. On this way some project that
traditional investment appraisal methods reject can be
accepted if has some potential (optional) value.
It is important to notice that real option methods are not
substitute for traditional investment appraisal methods but
their complement that enable wider insight of investment
judgment (Dixit, Pyndick, 1995).
Expanded (Strategic, Real option) NPV = Static (Passive)
NPV + Value of Options fromActive Management
In this paper traditional and real option investment
appraisal approach will be presented on the plum brandy
production in continental Croatia.
Objectives and hypothesis
The aim of this paper is to research increased significance
of the real option as modern investment appraisal methods
that have starting point on traditional investment analysis
with addition in form of project flexibility estimation.
According to the financial theory quantifying the main
investment scheme, this paper will compare results of the
traditional and modern real option investment analysis on
example of the plum brandy production. Author will with
that respect explore the next hypotheses:104
• TRADITIONAL METHODS OF INVESTMENT
ANALYSIS CAN UNDERVALUE INVESTMENT
OPPORTUNITIES BECAUSE THEY DO NOT
TAKE IN CONSIDERATION AN OPTIONAL
VALUE (POTENTIAL) OF INVESTMENT.
• ONLY TRADITIONAL METHODS FOR
INVESTMENT ANALYSIS ARE NOT ENOUGH
BECAUSE MODERN MANAGEMENT IS
FLEXIBLE. IT ACTIVELY TRIES TO FIND ALL
OPTIONS AND BENEFIT FROM THE CURRENT
BUSINESS POSITION.
These hypotheses can be divided on the next sub-
hypotheses:
1. Decision on investment is the most important financial
decision. It is a part of long-term business planning
process as well as strategic business definition.
2. Traditional methods of the investment appraisal are
often used for the tactical decision making level, not
in strategic level. These methods have the major
importance for the small, individual, irreversible and
independent project appraisal. Traditional methods
are not enough for the complex, independent and
multiphase projects appraisal.
3. Strategic of the capital planning that apply option
approach is the way of management flexibility
quantifying as well as measure of all interdependent
projects aspects.
In order to confirm or reject specified hypotheses this
paper is asking to offer the answers on the next questions:
1. What methods for investment appraisal purpose
traditional (conventional) investment analysis use?
2. What are advantages and disadvantages of the
traditional investment analysis?
3. What are the major characteristics of the modern
investment analysis approach, generally real option
analysis?
4. What advantages and disadvantages of real option
analysis can be noticed?
5. What is the result of the traditional investment
analysis of the plum brandy production?
6. What is the result of the real option investment
analysis of the plum brandy production?
Final valutation of the project
As maintained before, the adjusted value of the project
should take in consideration an option value of the extended
project. In case of plum production it was identified that
plum plantation gives an option for distillery investment,
which will use the plum from the plantation as the input
source. Because of that, real value of plantation consists of
NPV of the future net cash flow as well as call option value
for distillery establishment.
Strategic NPV = Real option NPVplam plantation =
NPV + call option
Real option NPVplam plantation =
–2.036,18 EUR + 4.986,72 EUR = 2.950,54 EUR
(Black-Scholes option valuation)
or
Real option NPVplam plantation =
–2.036,18 EUR + 5.184,17 EUR = 3.147,99 EUR
(Binomial option valuation)
Real option calculation of NPV adjusted by the next
investment option value, gives considerably different results
than conventional NPV calculation. While the NPV without
option value indicates that plum production is not profitable
enough, this extended approach found that NPV is positive.
Therefore, investment in plum production with option of
distillery extension should be accepted.
If the whole project consisted of plum and plum brandy
production should be evaluated, the investment appraisal is
also enlarged by option value.
Real option NPVproject = NPV (plum) + call option
(brandy production)+NPV(plum brandy)
RO NPVproject = –2.036,18 EUR + 4.986,72 EUR +
2.996,18 EUR = 5.946,72 EUR (Black-Scholes)
RO NPVproject = –2.036,18 EUR + 2.996,18 EUR +
5.184,17 = 6.144,17 (Binomial method)
Recapitulation of the calculation
On example of plum brandy production, the call option
that exists in the plum plantation has been determined. Using
only traditional methods of project evaluation, the plum
plantation of 1 ha in current market condition hasn’t showed
satisfied results. But, traditional methods have ignored
hidden (potential) value that investment has. Traditional
methods neglect flexibility of management decision-making,
which is in compliance with actual market situation.
Plum plantation owner has different options:
• To withdraw the plantation after first negative results
caused by, for example, decrease of plum price.
• To enlarge a plantation hoping that results will be
better with higher production surface (economy of
scale).
• To change a technology in order to change target from
proceeding plum to fresh consumption plum.
• To expand plum production to plum processing
products (plum brandy, plum jam).
In our example, the option of plum brandy, as one of the
options, has been tested. Considering separately, plum brand
production ensures positive business performance, much better
than plum production only. Logically, plum plantation has a
certain optional value that raises a first project appraisal.
Lari Hadelan105
Using exclusively traditional approach there is no
possibility to evaluate this extension opportunity value.
Because of that, the project of plum production would be
rejected. Real option can overstep this shortage increasing
the project value by option value.
Consultation
A present business environment is very dynamic and it
takes a much of decision making, fast but rational. Because
of the irreversibility of the investment projects it is strongly
important to notice all the business opportunities that exist.
Traditional methods of investment appraisal cannot evaluate
these options and managerial flexibility appropriately. High
potential projects, that might turn out to be a valuable part of
future project portfolios might be abandoned completely
using a conventional NPV methodology. Therefore, real
options theory, a complement to DCF, needed in such cases,
adds that necessary flexibility. In the process, real options
theory addresses important strategic and financial issues.
Thanks to the analogy between
financial instruments investments and
real projects, the real option valuation
methods have been developed during
1970s’. In spite of some critics that
found different constraints of the real
option approach, today, it is unique
methods for the option valuation.
However, only 10% of all American
CFO use real option model in they
project planning.
Presented sample has been used for
simple understanding of the basic
principles of the real option model.The
only feasible way to value more
complicated projects is by using a
computer programmes. In this case a
project of the plum brandy production
hasbeentestedwithtraditionalandreal
option methods as well. Traditional
methods of plum plantation investment
appraisal haven’t given acceptable
estimation. Option’s methods have
taken in consideration optional value
that emerges from the plum plantation.
In case where plum brandy production
is offering an acceptable business
result, plum plantation value, as the
first phase of the brandy production should be increased by its
optional value. With this new perspective, the plum plantation
investment should be taken.
The main problem for faster real option acceptance is its
appliance in practical, not only in academics’ level. Hence,
academics must listen carefully to the critiques of practitioners
and allow them to influence the kinds of problems that are
addressed in academic research.
As the prerequisite for developing of the real option
approach it is needed to educate a student and entrepreneurs
about benefits of the real option methods and to recognize the
options in each practical sense. In this respect, I hope that this
thesis can provide an option to improve financial management
knowledge and increase the goodwill of its author and readers
as well.
References
Dixit, A, Pyndick, R.S. (1995): The Options Approach to Capital
Investment, Harvard Business Review, May/June, pp. 105–115.
Investment anakysis of plum brandy production – methodology approach
Table 1: Comparison of traditional and real option appraisal
Traditional Real option appraisal Real option appraisal
appraisal (Black-Scholes) (Binomial method)
NPV – plum plantation –2.036,18 EUR 2.950,54 EUR 3.147,99 EUR
Investment appraisal Not accepted Accepted Accepted
NPV - aggregated 960,00 EUR 5.946,72 EUR 6.144,17 EUR
Investment appraisal Accepted Accepted Accepted
Source:Author’s calculations
Source:Author’s calculations
-4000
-2000
0
2000
4000
6000
NPV (plums) NPV(project)
Graph 1: Traditional and RO NPV
traditional NPV real option NPV

Investment analysis of plum brandy production – methodology approach

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