Real Options Valuation Model Vs. Discounted Cash Flow

In an article posted on hbr.org, “It May Be Cheaper to Manufacture at Home,” Suzanne de Treville and Lenos Trigeorgis delve into the discussion of the real options valuation model when sourcing locally.  Many manufacturers prefer to use discounted cash flow (DCF) to help in supply chain decisions, especially where to locate a new plant.  However, DCF ultimately undervalues flexibility. Therefore, if something unexpected occurs, the expenses can amount quickly.  The best way to avoid this is to pair DCF with a real options valuation.  This gives flexibility in the supply chain by putting a dollar amount on it.

The article looks at how Flexcell, a Swiss company that produces various lightweight solar panels, was looking to expand operations.  The CEO came to the conclusion to build a new factory on Swiss soil, rather than offshoring, by looking beyond the DCF model.

“If the plant were in Switzerland, he could delay production commitments and investments for several months, during which he could gather critical information about demand. This decision allowed him to use the real options valuation framework, which in turn let him put a dollar figure on flexibility.”

For the full article, please visit hbr.org.