Making Real Options Really Work

Real options in the valuation, The real power of real options

This is the first of two articles which considers how real options can be incorporated into investment appraisal decisions.

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? In exploring their reservations about real-option analysis as a valuation methodology, we have come to the conclusion that much of the problem lies in the unspoken assumption that the real-option and DCF valuation methods are mutually exclusive.

This article discusses real options and then considers the types of real options calculations which may be encountered in Advanced Financial Management, through three examples.

The article then considers the limitations of the application of real options in practice and how some of these may be mitigated.

Adjusting for Cost

The second article considers a more complex scenario and examines how the results produced from using real options with NPV valuations can be used by managers when making strategic decisions.

Net present value NPV and real options The conventional NPV method assumes that a project commences immediately and proceeds until it finishes, as originally predicted.

The Value of Real Options

Therefore it assumes that a decision has to be made on a now or never basis, and once made, it cannot be changed. It does not recognise that most investment appraisal decisions are flexible and give managers a choice of what actions to undertake.

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. Real options differ thus from financial options contracts since they involve real i. Key Takeaways A real option gives a firm's management the right, but not the obligation to undertake certain business opportunities or investments.

The real options method estimates a value for this flexibility and choice, which is present when managers are making a decision on whether or not to undertake a project. Real options build on net present value in situations where uncertainty exists and, for example: i when the decision does not have to be made on a now or never basis, but can be delayed, ii when a decision can be changed once it has been real options in the valuation, or iii when there are opportunities to exploit in the future contingent on an initial project being undertaken.

Therefore, where an organisation has some flexibility in the decision that has been, or is going to be made, an option exists for the organisation to alter its decision at a future real options in the valuation and this choice has a value.

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Options, on the other hand, view risks and uncertainties as opportunities, where upside outcomes can be exploited, but the organisation has the option to disregard any downside impact. Real options methodology takes into account the time available before a decision has to be made and the risks and uncertainties attached to a project.

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".

It uses these factors to estimate an additional value that can be attributable to the project. In addition to this, candidates are expected to be able to explain but not compute the value of redeployment or switching options, where assets used in projects can be switched to other projects and activities. For the Advanced Financial Management exam purposes, it can be assumed that real options are European-style options, which can be exercised at a particular time in the future and their value will be estimated using the Black-Scholes Option Pricing BSOP model and the put-call parity to estimate the option values.

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Five variables are used in calculating the value of real options using the BSOP model as follows: The underlying asset value Pawhich is the present value of future cash flows arising from the project.

The exercise price Option simple examplewhich is the amount paid when the call option is exercised or amount received if the put option is exercised. The risk-free rwhich is normally given or taken from the return offered by a short-dated government bill. Although this is normally the discrete annualised rate and the BSOP model uses the continuously compounded rate, for Advanced Financial Management purposes the continuous and discrete rates can be assumed to be the same when estimating the value of real options.

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The volatility swhich is the risk attached to the project or underlying asset, measured by the standard deviation. The time twhich is the time, in years, that is left before the opportunity to exercise ends.

The following three examples demonstrate how the BSOP model can be used to estimate the value of each of the three types of options. The company has forecast the following end of year cash flows for the four-year project.

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