WHAT IS A REAL OPTION?• A situation in which an investor is able to choose between two different investments where both choices involve tangible assets. The investor may choose between assets; like land or inventory; financial instruments like stocks and bonds are not involved in a real option.• Real options, as a discipline, extends from its application in corporate finance, to decision making under uncertainity in general, adapting the techniques developed for financial options to "real-life" decisions.• It should be noted that a real option has nothing to do with an option contract.
• Real option applies option valuation techniques to capital budgeting decisions.• Real options represent a company’s rights to make chronological decisions in a capital project.• Real options increase the NPV of a project because a firm would not rationally exercise an option which lowers value.• They are referred to as "real" because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments.
TYPES OF REAL OPTIONS• 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.1. Option to expand2. Option to contract3. Option to expand or contract (Switching option)• Options relating to project life and timing; they refer to the option to exercise only those projects that appear to be profitable at the time of initiation.1. Initiation or deferment options2. Option to abandon (Termination option)3. Sequencing options
• Options relating to project operation; management may have flexibility relating to the product produced and /or the process used in manufacture.This flexibility constitutes optionality.1. Output mix options (product flexibility)2. Input mix options (process flexibility)3. Operating scale options (Intensity options)
Five Procedures for Valuing Real Options1. Discounted cash flows analysis of expected cash flows, ignoring the option.2. Qualitative assessment of the real option’s value.3. Decision tree analysis.4. Standard model for a corresponding financial option.5. Financial engineering techniques.
Analysis of a Real Option: A Numerical Example• Initial cost = $70 million, Cost of Capital = 10%, risk-free rate = 6%, cash flows occur for 3 years. AnnualDemand Probability Cash Flow High 30% $45 Average 40% $30 Low 30% $15
Investment Timing Option• If we wait one year, we will gain additional information regarding demand.• If demand is low, we won’t implement project.• If we wait, the up-front cost and cash flows will stay the same, except they will be shifted ahead by a year.
Procedure 2: Qualitative Assessment• The value of any real option increases if: – the underlying project is very risky – there is a long time before you must exercise the option• This project is risky and has one year before we must decide, so the option to wait is probably valuable.
Procedure 3: Decision Tree Analysis (Implement only if demand is not low.) C ost F utur e C a sh F low s N P V th is a2001 P r ob . 2002 2003 2004 2005 S c e n a r io -$ 7 0 $45 $45 $45 $ 3 5 .7 0 30% $0 40% -$ 7 0 $30 $30 $30 $ 1 .7 9 30% $0 $0 $0 $0 $ 0 .0 0 Discount the cost of the project at the risk-free rate, since the cost is known. Discount the operating cash flows at the cost of capital. Example: $35.70 = -$70/1.06 + $45/1.12 + $45/1.13 + $45/1.14.
• Use these scenarios, with their given probabilities, to find the project’s expected NPV if we wait.• E(NPV) = 0.3($35.70)+0.4($1.79) + 0.3 ($0) = $11.42.