A Case Study on Automotive Battery System Design - Title Page - MIT

Chapter 3: Flexibility Valuation Modeling Approaches With RealOptionsTraditional business case models use point forecasts to determine the Net Present Value (NPV)of a project. NPV is used to compare projects at “present value.” It assumes that future cashflows are worth less than current cash flows, as are future capital expenditures (CAPEX). Theequation for NPV is defined as:where n is the period over which the analysis is done (often in “years”), r is the discount rate, orthe competing rate of interest as a benchmark, and CF is the cash flow. For a very safeinvestment, the discount rate might be the rate on a similar US Treasury bill. For a riskierinvestment, such as a startup venture, a substantially higher interest rate may be used. A shorttermCAPEX would be a negative cash flow at year 0, while sales in year 10 would providepositive cash flows.A traditional model might project a 10-year demand curve, sales price, and unit cost, providingcash value for comparison across various competing projects. Design decisions would be madefrom this point forecast, treating future estimates as “fact”. At best, the future is incrediblydifficult to predict, even in the short term. At worst, it is impossible.Assuming static behavior in an NPV assumes a priori knowledge of future conditions.Additionally, this type of financial model assumes passive management; incoming data does not21