Real Options Analysis

Real Options Analysis values the underlying options present in all investment decision-making embarked on by management and brings into  play managerial flexibility in making  mid course corrections to their decisions along the way.

Traditional strategic financial plans using Discounted Cash Flows (DCF) are static plans that are based on the assumption best described by Amram & Kulatilaka,  that the firm is faced with a ‘now or never’ investment (without the option to wait), that the investment in assets like plant and machinery will be made in a single lump sum, and that management (after resolving key issues at the start of the process) will remain passive thereafter.

In reality however managers treat decisions to invest in new strategies and assets as a series of cash flows plus a set of options eg. The option to stage the investment or delay the investment to resolve uncertainty with the passage of time, or the option to abandon an investment midway (or at any time for that matter), the option to grow or the option to change key processes and so on.

This flexibility has enormous value in conditions of uncertainty. The higher the uncertainty, the higher the volatility of the cash flows and therefore the greater is the value of the option (typically to wait , to learn, to stage, or to abandon an investment midway).

Standard discounting processes penalise risk and uncertainty by applying  higher discount rates. In reality managers dislike exercising the option to invest until the uncertainty surrounding the project is resolved. This creates a dysfunction between the strategic planning process and what managers actually do.

Real Options Analysis values this managerial flexibity as a set of options, and uses option valuation theory and techniques to value them.

 An option is a ‘right’ but not an obligation to take an action in the future. Options are therefore valuable when there is uncertainty, and when there is sufficient time for all, or many, outcomes to occur.

Real options are options that are not traded (like financial options) but embedded in the investment decisions that managers make. Managers may choose to exercise the option to invest and capture the immediate benefits of an investment, delay an investment to resolve uncertainty, stage an investment to mitigate risk, or expand, contract, or even abandon a project (or parts of a project) at any given time.

Correspondingly ROV ensures that the downside risk and uncertainty is removed, as managers will not exercise the right to invest unless they have resolved the uncertainty and are confident of the upside. If the downside eventuates, managers will not invest or having invested will abandon.

Real Options are valued as  ‘Call Options’ when they provide management with the ‘right’ but ‘not the obligation’ to learn, delay, defer, expand or stage an investment. Conversely they are valued as  ‘Put Options’ when they permit management the ‘right’ but ‘not the obligation’ to contract or even abandon a project at any time in its life.  The exercise price is the outlay for Call options and the abandonment or scrap value for Put options.

In option valuation theory ‘European Options’ can be exercised only on expiry. ‘American Options’ can be exercised at any time until they expire. Most ‘real options are ‘American Options’.