Use of real options

Real Option

Using real options in strategic decision use of real options by Chris Walters and Tim Giles of London Economics Spring To maximize a firm's value its managers must match internal capabilities to external opportunities. Flexibility in timing of decisions about the firm's capabilities and opportunities give managers 'real options'.

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What are they and how do we use them? There are four components in the manager's toolkit for valuing investment opportunities: payback rules, accounting rates of return, net present values NPV and real options.

use of real options

Payback rules ask how many periods management must wait before cumulated cash flows from the project exceed the cost of the investment project.

If this number of periods is less than or equal to the firm's benchmark, the project gets the go-ahead.

CFOs tell us that real options overestimate the value of uncertain projects, encouraging companies to overinvest in them. These concerns are legitimate, but we believe that abandoning real options as a valuation model is just as bad. How can managers escape this dilemma?

Subsequent cash flows, whether positive or negative, are not factored into the calculation. One example of an accounting rate of return is the ratio of the average forecast profits over the project's lifetime after depreciation and tax to the average book value of the investment.

Real options valuation

Again comparison with a threshold rate is sought before investment goes ahead. Both these measures enjoy the benefit of simplicity. Cash flows are easier to forecast in the near future than the distant future, so a payback rule can be implemented more accurately. And accounting rates of return are computed from data that is routinely compiled by management accountants, making comparison and monitoring relatively easy.

Making Real Options Really Work

To implement NPV, we need estimates of expected future cash flows and an appropriate discount rate. And there's use of real options rub. An NPV calculation only uses information that is known at the time of the appraisal.

A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities.

To borrow a popular metaphor, think of poker. How much would you place as your final bet before the first card had been dealt? This example brings out starkly the problem of uncertainty.

use of real options

You are being asked to make an NPV calculation using only what is known before the game begins. And your choice is all-or-nothing, not an initial choice followed by more choices as information becomes available.

use of real options

In poker, players pay a small amount to stay in the game. Depending on the next turn of the card, they then fold, match or raise the bet. NPV techniques were first developed to value bonds.

The real power of real options

There is little investors in bonds can do to alter the coupons they receive or the final principal paid the future cash flowsor the yield rate the appropriate discount rate. Companies, however, are not passive investors: managers have the flexibility to sell the asset, invest further, wait and see or abandon the project entirely. It is precisely the way in which real options deal with uncertainty and flexibility that generates their value.

Real options are not just about "getting a number", they also provide a useful framework for strategic decision making.

So what is a real option? It is the right - but not the obligation - to acquire the gross present value of expected cash flows by making an irreversible investment on or before the date the opportunity ceases to be available.

  1. Real Option Definition
  2. Types of real options[ edit ] Simple Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from "Investment Example".

Although this sounds similar to NPV, real options only have value when investment involves an irreversible cost in an uncertain environment. And the beneficial asymmetry between the right and the obligation to invest under these conditions is what generates the option's value.

Consider an investment project where there is uncertainty about the state of the world. Suppose it can be either good or bad and it's as likely to be one as the other.

use of real options

So flexibility can be profitable! This flexibility has several strategic forms. Using real options values the ability to invest now and make follow-up investments later if the original project is a success a growth option.

Real options can also value the ability to abandon the project if it is unsuccessful an exit option.

use of real options

A North Sea oil company has had much well-publicised success valuing its 5-year oil and gas exploration licenses in this way. And real options can value the ability to wait and learn, resolving uncertainty, before investing a timing option. Eurotunnel has a statutory option on a second tunnel under the English Channel, to be use of real options not earlier than its lease on the first tunnel expires in The current fixed link came in one year late and 11 billion over budget.

use of real options

What price the ability to resolve uncertainty this time? If real options only have value when costs are sunk and returns uncertain, what exactly determines their value? In order to exercise a real option, you must pay the exercise price.