A project is one’s dream. After passing the consent to start the work, it becomes the life of many workers. Sometimes, there occur cases where the project gets canceled or the parameters have to redesign for producing more amounts. To get an extra benefit is really valuable with regard to a project’s view and should be definitely included in the related calculations. This rethinking coincides with the term ‘flexibility’.
In the above-mentioned case, flexibility comes in different modes. Either you have the option to completely drop the project, or you might come up with a large factory project of the same line with an option of expansion in future and so many. It is quite observable that some proposals are more flexible than others and this should be definitely taken into account while determining the scheme and value of the project.
This ability to have a number of flexibility ideas for a project is often known as having a real option. This name suggestion came from the similarity it has with a financial option
The case of unequal project comparison
Let us start with an example for easy understanding: Consider a simple case of buying two different varieties of tube lights for your business firm of which one is low-priced but it comes with a lifetime guarantee of 1 year and the other one is quite expensive but last for 4 years and comes with an energy saving mode. So how and which option to choose becomes our point of consideration.
Thus, it can be said this is a special type of project structural evaluation which involves comparison of more than two options which needs repeated purchases but stays for totally different time spans. Even though this case sounds unusual, this really happens in a number of situations.
In the case discussed above, the cash payment is to be done initially for the purchase of the tube light and later also you have to continue paying for the electricity used by the tube. You can clearly observe no cash flowing at any time. But we need to get the tube as they get their part done but cost differently right?
There are two of ways to compare such projects
- Replacement chain method: This implicates the idea that though the first one is cheaper in terms of cost, they will have to be replaced sooner and so better go for the second one.
- Equivalent Annual Annuity: This is an evaluation where all the expense and benefits of the product are transferred into cash value yearly.
These circumstances of cash flow can always be accounted for calculating capital budgeting of a project.