Contact What is real options theory? Definition and meaning Real options theory is a modern theory on how to make decisions regarding investments when the future is uncertain. Real options theory draws parallels between the valuation of the financial options available and the real economy.
The theory has become a popular theme in most business schools across the world, as well as the boardroom, especially within oil companies. Examples of real options include determining whether to build a new factory, change the machinery and technology on a production line, decide whether to buy potentially lucrative oil fields and when to start drilling or pumping, etc. They do not include derivative financial instruments such as stocks or bonds.
Real options theory is based on logical financial options in capital investments in the sense that they create a certain level of valuable flexibility. If you have financial options, you then have the freedom to make the best choices and decisions, such as where and when to make a specific capital investment.
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- Value of the option in the money
The investment choices we have with tangible assets are similar to those that exist with financial instruments. In theory, tangible assets real assets could be valued according to the same methodology. In other words, the project is like an option: there is an opportunity, but not an obligation, to go ahead with it.
The expected cash flows are discounted at the capital cost for the company, and trend line by method results are added up. If the NPV is zero, it makes no difference to the company whether the project is approved or turned down.
Real options valuation
If it is greater than zero, NPV theory tells us to go ahead with the project. The higher the managerial freedom degree, the higher is the value of the investment opportunity. For most capital investment in petroleum industry, the timing is the main option to be considered. In many cases, for large sunk cost like investment in offshore petroleum fields, is possible to consider only the timing option. In petroleum exploration contract auctions, it is common for the largest bids to be greater than the net present value calculation.
This is because the winning bidder was aware that as soon as some initial drilling was completed, the company could — on the basis of the new information gathered from that initial digging — stop the exploration or expand it. As occurs with financial options, the key question is using the theory of real options to exercise using the theory of real options option: certainly not when the company has no funds the cost of investing is greater than the benefit.
Investors in financial options should not necessarily invest as soon as they have money, when the benefit of making that choice is greater than the cost — a better option may be to wait until it has lots of money, when the benefits are considerably greater than the cost.
Similarly, firms should not always invest as soon as their project has an NPV equal to or marginally greater than zero — waiting might be better. When the cost of investing is much less than the benefit Real options theory allows you to wait until you are here before deciding to approve the project Real options theory — an example The majority of companies have embedded in them investment opportunities with a range of managerial options. For example, imagine an oil company whose management thinks using the theory of real options has discovered a new oil field.
However, nobody knows exactly how much oil is in there — neither do they know what the oil price will be when they start pumping that oil. They have two decisions to make: — Purchase the lease and start drilling? We know that oil prices can fluctuate significantly.
The standard theory it modifies is the Expect Net Present Value theory of investment decision. According to NPV theory the future cash flows of an investment project are estimated and if there is uncertainty about those cash flow the expected value determined. The expected cash flows are discounted at the cost of capital for the corporation and the results summed.
So, it would make more sense to wait until oil prices were considerably higher than an NPV equation of slightly more than or equal to zero before giving the go-ahead. In practice, however, valuing real options is extremely difficult, as are pricing the financial options.
Video — What are real options? It starts by comparing them to financial options.
Jun 08, 16 min read by Chris Matts Whether people realise it or not, "freedom to choose" is the underlying principle behind many of the agile practices.