Texaco: A Real Options Analysis

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Discounted Cash Flow Analysis versus Real Options Analysis According to Chapter 13 of the Fundamentals of Financial Management text, the traditional method used for evaluating capital investments was the discounted cash flow (DCF) analysis method, which has been used since the 1950s (Brigham & Houston, 2007, p. 416). The DCF method takes estimated cash flows and discounts them back to the expected Net Present Value (NPV). In recent years, many companies, particularly those in oil, energy and pharmaceutical industries have begun to make capital budgeting decisions using real options analysis (Sammer, 2002). This could be attributed to demonstrations over time that the traditional DCF method may not lead to accurate capital budgeting decisions (Brigham & Houston, 2007, p.416). As opposed to the simple DCF method, real options analysis “takes into account the risks and rewards of future uncertainty or volatility” (Paul-Choudhury, 1999). Many companies, like Texaco, Inc. (now ChevronTexaco) are now leaning towards the real options method and using it as a complimentary technique to the more traditional methods such as DCF and decision-tree analysis, instead of as a stand-alone method of valuation (Benoît Couët et al., 2003). Incorporating Real Option Analysis at Texaco Soussan Faiz, a former manager of global valuation service at Texaco (Paul-Choudhury, 1999), was charged in the mid-1990s, with determining whether the firm should maintain and commercialize a “substantial, long-held lease in a developing country” or if they should exit the lease (Sammer, 2002). This had become a source of debate among many of Texaco’s executive management team, in which some believed the lease to be worthless and wanted to use the proceeds from the sale for other capital investments, while others thought it could prove to be profitable and was worth further exploitation

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