# Investment valuation of the project based on real options

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".

Consider a firm that has the option to invest in a new factory. It can invest this year or next year.

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.

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.

### Integrating Options and Discounted Cash Flow

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 The investment cost is 4M. If the firm invests next year, the present value of the investment cost is 3.

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.

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 Thus the value to invest next year is 1. 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.

## Investment appraisal and real options | ACCA Qualification | Students | ACCA Global

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.

This is adapted from "Staged Investment Example". The firm does not know how well its stores are accepted in a foreign country. If their stores have high demand, the investment valuation of the project based on real options cash flows per store is 10M. If their stores have low demand, the discounted cash flows per store is 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 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 But is it the best alternative? Following real options valuation, it is investment valuation of the project based on real options 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.

The value to open one store this year is 7.

Thus the value of the real option to invest in one store, wait a year, and invest next year is 0. Given this, the firm should opt by opening one store.

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This simple example shows that a negative net present value does not imply that the firm should not invest. Options relating to project size[ edit ] Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.

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 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.

A project with the option to expand will cost more to establish, the excess being the option premiumbut 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 optionand 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 optionand 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[ edit ] 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.

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.

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Once resolved, management has the option to proceed or not with the development of the other projects.