Real options valuation, also often termed real options analysis,Adam Borison (Stanford University). Real Options Analysis: Where are the Emperor's Clothes?. (ROV or ROA) applies option valuation techniques to capital budgeting decisions.Campbell, R. Harvey. Identifying real options, Duke University, 2002. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, real options valuation could examine the opportunity to invest in the expansion of a firm's factory and the alternative option to sell the factory.Nijssen, E. (2014). Entrepreneurial Marketing; an effectual approach. Chapter 2, Routledge, 2014. Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options.
Scope Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security.Amram, M., and K. N. Howe (2003), Real Options Valuations: Taking Out the Rocket Science , Strategic Finance, Feb. 2003, 10-13. A further distinction is that option holders here, i.e. management, can directly influence the value of the option's underlying project; whereas this is not a consideration regarding the underlying security of a financial option. Moreover, management cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike financial options, management must also create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task.
Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to "real-life" decisions. For example, R&D managers can use real options valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects. Non-business examples might be evaluating the cost of cryptocurrency mining machines, or the decision to join the work force, or rather, to forgo several years of income to attend graduate school.See Bilkic et al. under #Applications. It, thus, forces decision makers to be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business strategy formulation.Justin Pettit: Applications in Real Options and Value-based Strategy; Ch.4. in Trigeorgis (1996)Joanne Sammer: Thinking in Real (Options) Time, businessfinancemag.comDavid Shimko (2009). Real Options: Opportunity from Risk. archived 2010-04-05. This extension of real options to real-world projects often requires customized decision support systems, because otherwise the complex compound real options will become too intractable to handle.
Types of real options
+ Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information.
Consider a firm that has the option to invest in a new factory. It can invest this year or next year. The question is: when should the firm invest? If the firm invests this year, it has an income stream earlier. But, if it invests next year, the firm obtains further information about the state of the economy, which can prevent it from investing with losses.
The firm knows its discounted cash flows if it invests this year: 5M. If it invests next year, the discounted cash flows are 6M with a 66.7% probability, and 3M with a 33.3% probability. Assuming a risk neutral rate of 10%, future discounted cash flows are, in present terms, 5.45M and 2.73M, respectively. The investment cost is 4M. If the firm invests next year, the present value of the investment cost is 3.63M.
Following the net present value rule for investment, the firm should invest this year because the discounted cash flows (5M) are greater than the investment costs (4M) by 1M. Yet, if the firm waits for next year, it only invests if discounted cash flows do not decrease. If discounted cash flows decrease to 3M, then investment is no longer profitable. If, they grow to 6M, then the firm invests. This implies that the firm invests next year with a 66.7% probability and earns 5.45M - 3.63M if it does invest. Thus the value to invest next year is 1.21M. Given that the value to invest next year exceeds the value to invest this year, the firm should wait for further information to prevent losses. This simple example shows how the net present value may lead the firm to take unnecessary risk, which could be prevented by real options valuation.
Staged Investment Staged investments are quite often in the pharmaceutical, mineral, and oil industries. In this example, it is studied a staged investment abroad in which a firm decides whether to open one or two stores in a foreign country.
The firm does not know how well its stores are accepted in a foreign country. If their stores have high demand, the discounted cash flows per store is 10M. If their stores have low demand, the discounted cash flows per store is 5M. Assuming that the probability of both events is 50%, the expected discounted cash flows per store is 7.5M. It is also known that if the store's demand is independent of the store: if one store has high demand, the other also has high demand. The risk neutral rate is 10%. The investment cost per store is 8M.
Should the firm invest in one store, two stores, or not invest? The net present value suggests the firm should not invest: the net present value is -0.5M per store. But is it the best alternative? Following real options valuation, it is not: the firm has the real option to open one store this year, wait a year to know its demand, and invest in the new store next year if demand is high.
By opening one store, the firm knows that the probability of high demand is 50%. The expected value today of the option of expanding next year is thus 50% * (10M - 8M) / (1 + 10%) = 0.91M. The value of opening one store this year is 7.5M - 8M = -0.5M. Thus the value of the real option to invest in one store, wait a year, and invest next year is 0.41M. Given this, the firm should opt by opening one store. This simple example shows that a negative net present value does not imply that the firm should not invest. The flexibility available to management – i.e. the actual "real options" – generically, will relate to project size, project timing, and the operation of the project once established.This section draws primarily on Campbell R. Harvey: Identifying Real Options. In all cases, any (non-recoverable) upfront expenditure related to this flexibility is the option premium. Real options are also commonly applied to stock valuation - see - as well as to various other "Applications" referenced below.
Options relating to project size Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.This sub-section is additionally based on Aswath Damodaran: The Option to Expand and Abandon.
Option to expand: Here the project is built with capacity in excess of the expected level of output so that it can produce at higher rates if needed. Management then has the option (but not the obligation) to expand – i.e. exercise the option – should conditions turn out to be favourable. A project with the option to expand will cost more to establish, the excess being the option premium, but is worth more than the same without the possibility of expansion. This is equivalent to a call option. Option to contract: The project is engineered such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future expenditures constitutes option exercise. This is the equivalent to a put option, and again, the excess upfront expenditure is the option premium. Option to expand or contract: Here the project is designed such that its operation can be dynamically turned on and off. Management may shut down part or all of the operation when conditions are unfavorable (a put option), and may restart operations when conditions improve (a call option). A flexible manufacturing system (FMS) is a good example of this type of option. This option is also known as a Switching option.
Options relating to project life and timing Where there is uncertainty as to when, and how, business or other conditions will eventuate, flexibility as to the timing of the relevant project(s) is valuable, and constitutes optionality. Growth options: perhaps the most generic in this category – these entail the call option to exercise only those projects that appear to be profitable at the time of initiation. Initiation or deferment options: Here management has flexibility as to when to start a project. For example, in natural resource exploration a firm can delay mining a deposit until market conditions are favorable. This constitutes an American styled call option. Delay option with a product patent: A firm with a patent right on a product has a right to develop and market the product exclusively until the expiration of the patent. The firm will market and develop the product only if the present value of the expected cash flows from the product sales exceeds the cost of development. If this does not occur, the firm can shelve the patent and not incur any further costs. Option to abandon: Management may have the option to cease a project during its life, and, possibly, to realise its salvage value. Here, when the present value of the remaining cash flows falls below the liquidation value, the asset may be sold, and this act is effectively the exercising of a put option. This option is also known as a Termination option. Abandonment options are American styled. Sequencing options: This option is related to the initiation option above, although entails flexibility as to the timing of more than one inter-related projects: the analysis here is as to whether it is advantageous to implement these sequentially or in parallel. Here, observing the outcomes relating to the first project, the firm can resolve some of the uncertainty relating to the venture overall. Once resolved, management has the option to proceed or not with the development of the other projects. If taken in parallel, management would have already spent the resources and the value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy. Related here is also the notion of Intraproject vs. Interproject options.
Options relating to project operation Management may have flexibility relating to the product produced and/or the process used in manufacture. As in the preceding cases, this flexibility increases the value but also the cost of the project; the latter corresponding, in turn, to the "premium" paid for the real option. Output mix options: The option to produce different outputs from the same facility – product flexibility – is known as an output mix option. These options are particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good are typically low, and management would wish to change to a different product quickly if required.