This is the first of two articles which considers how real options can be incorporated into investment appraisal decisions. 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 authors would like to thank two anonymous referees and the editors for helpful comments, while retaining responsibility for all remaining errors and omissions. Abstract During recent years, real options have emerged as one of the most actively researched topics in finance and related fields. A quarter of a century since the first appearence of the term, this article sets out to review the main contributions to real options theory and assess their impact on our understanding of managerial behavior in an environment characterized by economic uncertainty and flexibility. Next to the option pricing foundations, the article emphasizes the role of real options for the extraction and commercialization of natural resources, research and development, corporate risk management and foreign direct investment, production flexibilities, as well as game-theoretic treatments of corporate investment decisions.
The article then considers the limitations of the application of real options in practice and how some of these may be mitigated. 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.
CA Final - SFM - Capital Budgeting - Real Option, Base NPV and Adjusted NPV - CA Learning
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.
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 made, 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 date and this choice has a value. 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. 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.
Five variables are used in calculating the value of real valuation of investments by the method 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.
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.
The exercise price Pewhich 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.
Hay Jin Kim provided valuable assistance. Email: eduardo. This paper provides an overview of the real options approach to valuation mainly from the point of view of the author who has worked in this area for over 30 years.
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.
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.