David R. Williams
Paul H. Hammes

Real option logic places value on innovation and allows CFOs to grow the business systematically.


At a Glance

Given the increasing market and technological uncertainty of capital investments, healthcare financial executives need to incorporate flexibility into their decision making. Traditional capital budgeting techniques do not take into consideration the need for flexibility, changes in the environment, or actions by management. In response, practitioners from various industries have adopted a new way of looking at capital investments: real options.


Healthcare CFOs have traditionally worn two hats: gatekeeper and steward of financial resources, and facilitator of growth and expansion. Increasingly, healthcare financial managers are being asked not just to facilitate but also to find new revenue streams. For many organizations that are no longer significantly able to decrease costs, entrepreneurial growth has become the mantra of their CEOs and boards. Simultaneously, staff members involved with strategic development and department heads seeking to update and expand their technologies and services are constantly competing for the CFO's time and the organization's resources. Yet the unbridled growth and diversification strategies of the 1990s remain fresh in many CFOs' minds.

In the role as gatekeeper and facilitator, the CFO assesses these new growth and technology efforts. This assessment typically involves creating business plans and spreadsheets using three- or five-year projections and discounting the proposed project based on internally generated hurdle rates. However, traditional financial approaches such as the discounted cash-flow method do not adequately assist in discerning the value of many of these efforts and technologies. Especially troubling for some organizations is that the net present value approach typically undervalues innovation. Nor does the NPV approach adequately reflect the actions of management or changes in the environment. The NPV approach requires that one make a decision today without the ability to change assumptions as events transpire. Thus, from the NPV perspective, decisions are irreversible-a position with which few financial managers would agree.

To address this issue, scholars working in financial economics and decision sciences have recently begun thinking differently about capital budgeting decisions in conditions of uncertainty where strategic and operating flexibility may affect the value of a project. This body of work is known as real options. Its origins derive from the Black and Scholes option-pricing model for financial options.a From the real option perspective, capital budgeting decisions can be thought of as similar to financial options-either a call option or a put option. A healthcare example of a call real option is when a hospital takes a lease-to-own option on a piece of equipment, say a mobile positive emission tomography scan. It builds a platform for this leased equipment. If demand for the PET service is as expected (or better), it may exercise its option to purchase the piece of equipment. Should the PET usage be less than expected, it allows the lease to expire (or puts the option). The sunk cost of the lease and platform is the initial price of the option. The advantage of the real option is that it conserves one's claim on the opportunity at hand without forcing one to make a commitment to it today.

Smyth and Swinand introduced readers of hfm to the real option pricing approach back in 2002.b In their article, they compare the NPV approach to the real options approach to capital budgeting using the example of an acquisition of a hospital. They also note that there are several different types or characteristics of real options, including the option to defer, time-to-build, expand or contract, abandon, switch, or enter new businesses or markets. To this list, we add the option to slow-down, speed-up, sell, and sequence. Each one of these options (and combinations of these options) represents latent value that is not accounted for in the NPV approach.

Though the real option pricing method has not yet gained widespread usage, practitioners and researchers continue to see the value of applying the cognitive or strategic aspects of real options or real option logic to both capital and noncapital budgeting items.c Noncapital real options include such items as investing in a managed care product, temporary versus permanent employment relations, and joining a group purchasing organization as a participant rather than owner. Real option logic allows organizations to test the assumptions incrementally before making large capital commitments. Real option logic also allows for exploration and prioritization or sequencing of capital budgets (i.e., an organization may not have the resources to acquire all capital equipment requested, but may be able to acquire a few and make modest option investment in others to glean information for future decisions). In other words, real option logic allows an organization to get information about a project or piece of equipment with minimum investment. Similar to financial options, the greater the uncertainty with respect to the distribution of the results, the more value the option has.

Admittedly, real option pricing may not be appropriate or necessary for all capital budgeting items (i.e., those with greater certainty). Executives should use traditional approaches (e.g., NPV) when there is less uncertainty. Real option logic is especially useful in areas that are more entrepreneurial in nature-areas containing greater uncertainty. An inherent problem for CFOs is understanding the levels of risk each entrepreneurial capital budgeting item poses individually and collectively. For example, within a budget cycle if each department of a hospital requests two to three capital budgeting items for funding, the CFO may be faced with 40 to 60 (or more) items to assess.

Without some type of assessment vehicle or tool, the CFO may not collectively be able to judge the overall risk exposure for the organization with respect to its capital budgeting expenditures. For entrepreneurial hospitals, this risk may be greater than expected. The real option pricing method may help with individual capital budgeting items but does not give an overall view of the types of risk that the organization is pursuing. Thus, financial managers need a way or tool to view all capital budgeting items simultaneously outlining their risk. 

Entrepreneurial Real Options

For financial and strategic managers, entrepreneurial ventures represent some of the most difficult areas to assess, particularly for organizations considering multiple entrepreneurial ventures simultaneously (i.e., a portfolio of real options). Thinking of entrepreneurial and strategic initiatives as a portfolio of options helps clarify and systematize risk.

To help managers assess the risk associated with a portfolio of real options, researchers have suggested differentiating real options (and other strategic initiatives) based on market and technological risk.d Market uncertainty is usually specific to a particular locale. Exhibit 1 can help an organization's CFO and others get a sense of how much risk and what kind of risk (e.g., technological or market [reimbursement and demand]) the organization is pursuing. 

 View Exhibit 1

f_williams_sidebar  

After reviewing the exhibit, the organization can determine whether it wishes to be more or less entrepreneurial in general or related to a specific area (i.e., does the organization wish to pursue or diminish technological or market risk).

Within Exhibit 2 are two types of initiatives: launches and real options. Launches represent initiatives that have less uncertainty, and the NPV approach may work as well as a real options approach. These launches are called enhancement and platform launches. Enhancement launches are new attributes to existing products, services, or service lines. Real options, on the other hand, are initiatives with greater uncertainty, and thus a real options pricing or logic approach is more appropriate. These real options are called positioning, scouting, and stepping-stones. The distinction between these real options is based on the nature of the uncertainty the health system faces-whether these are market uncertainties or technological uncertainties. Positioning options have high technical uncertainty but low market uncertainty. Scouting options have low technical uncertainty but high market uncertainty. Stepping-stone options have high market and technical uncertainties.

View Exhibit 2   

f_williams_exh1  

Initially, each department should create its own diagram similar to the exhibit and during the capital budgeting process, together with financial management personnel, create an organization-specific exhibit. Though subjective in nature, looking at capital budgeting expenditures in this manner will help financial managers better understand their organization's overall risk. 

Opportunities for Learning

Traditional capital budgeting approaches also tend to create a logic of their own. As mentioned earlier, the NPV approach does not allow for irreversibility. Thus, the mindset that it imposes on financial managers, strategic managers, and department directors is that if the NPV associated with the analysis is greater than zero, managers should pursue the project-solidifying the view that the project should be undertaken as proposed and without regard to changing conditions. This mindset leads to an aversion to change and a view that to change course is a type of failure.

However, taking a real options logic approach at the start and developing contingencies with managers tends to lessen the view that to alter course is a type of failure. In fact, real option logic promotes entrepreneurial thinking and action. Thus, managers know from the beginning that change (including abandonment of the project) is part of the process. Again, many managers use real option logic-though it is not stated as such-but for many, it is an unspoken or unacknowledged practice that sometimes leaves department directors bewildered as to how things changed. Where feasible, using real option pricing and logic will provide a better outcome for healthcare organizations dealing with uncertainty. Studies on the use of real options from other industries show that real option logic enhances exploration and learning. CFOs are increasingly being asked to explore their external environment and grow the business. A real options approach allows them to do this in a more systematic manner.


David R. Williams, PhD, FACHE, is assistant professor, health care management program, Department of Management, John A. Walker College of Business, Appalachian State University, Boone, N.C. (williamsdr@appstate.edu).

Paul H. Hammes is executive director, imaging and neurosciences, Forsyth Medical Center, Winston-Salem, N.C.


Footnotes

a.  See Smith, C. W., "Option Pricing: A Review," Journal of Financial Economics, March 1976, pp. 3-51, or Dixit, A. K., and Pindyck, R. S., Investment Under Uncertainty, Princeton, N.J.: Princeton University Press, 1994, for reviews of the literature.

b. Smyth, J. P., and Swinand, P., "Evaluating Capital Investment Opportunities: Capturing the Value of Flexibility," Healthcare Financial Management, November 2002, pp. 60-64. See Brealey, R. A., and Myers, S. C., Capital Investment and Valuation, New York: McGraw Hill, 2003, or Copeland, T., Koller, T., and Murrin, J., Valuation: Measuring and Managing the Value of Companies, New York: John Wiley & Sons, 2000, for calculating real options, which is beyond the scope of this article.

c. Busby, J. S., and Pitts, C. G. C., "Real Options and Capital Investment Decisions," Managerial Accounting, October 1997, pp. 38-39.

d. See McGrath, R., and MacMillan, I. C., The Entrepreneurial Mindset, Boston: Harvard Business School Press, 2000.

Publication Date: Tuesday, May 01, 2007

Login Required

If you are an existing member, please log in below. Username and password are required.

Username:

Password:

Forgot User Name?
Forgot Password?







Close

If you are not an HFMA member and would like to access portions of our content for 30 days, please fill out the following.

First Name:

Last Name:

Email:

   Become an HFMA member instead