Real options analysis

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In corporate finance, real options analysis or ROA applies put option and call option valuation techniques to capital budgeting decisions.[1] A real option itself, is the right—but not the obligation—to undertake some business decision; typically the option to make, or abandon, a capital investment. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real option.

ROA is often contrasted with more standard techniques of capital budgeting (such as NPV), where only the most likely or representative outcomes are modelled, and "flexibility" of this type is thus "ignored"; see Valuing flexibility under Corporate finance. ROA is therefore additionally useful in that it forces decision makers to be explicit about the assumptions underlying their projections, and is increasingly employed as a tool in business strategy formulation.

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[edit] Considerations

In contrast to financial options, a real option is not often tradeable — e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision; however, some real options can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future. Some real options are proprietary (owned or exercisable by a single individual or a company); others are shared (can be exercised by many parties). Therefore, a project may have a portfolio of embedded real options; some of them can be mutually exclusive.

With real option analysis, uncertainty inherent in investment projects is usually accounted for by risk-adjusting probabilities (a technique known as the equivalent martingale approach). Cash flows can then be discounted at the risk-free rate. With regular DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate, (using e.g. the cost of capital) or the cash flows (using certainty equivalents). These methods normally do not properly account for changes in risk over a project's lifecycle and fail to appropriately adapt the risk adjustment.

The valuation methods generally employed are Closed form solutions - often modifications to Black Scholes - and binomial lattices. The latter are probably the most widely used. Specialised Monte Carlo Methods have also been developed and are increasingly applied particularly to high dimensional problems. When the Real Option can be modelled as a partial differential equation, then the related finite difference scheme is sometimes applied, although this is uncommon due to its mathematical sophistication.

In general, all of these methods are limited either as regards dimensionality, or as regards early exercise, or both; in selecting a model, analysts must usually trade off between these considerations. Sometimes, the stochastic nature of such projections can make analysis using the Monte Carlo method infeasible, necessitating more traditional investigatory methods, such as Robinson differentials. Other new methods have recently been introduced to simplify the calculation of the real option value and thus make the numerical use of the methods easier for practitioners; these include the Datar-Mathews method (2004,2007) and the Fuzzy Pay-Off Method for Real Option Valuation (2008).

[edit] History

Whereas business operators have been making capital investment decisions for centuries, the term "real option" is relatively new, and was coined by Professor Stewart Myers at the MIT Sloan School of Management in 1977. It is interesting to note though, that in 1930, Irving Fisher wrote explicitly of the "options" available to a business owner (The Theory of Interest, II.VIII). The description of such opportunities as "real options", however, followed on the development of analytical techniques for financial options, such as Black–Scholes in 1973. As such, the term "real option" itself is closely tied to these new methods.

Real options are today an active field of academic research. Professor Lenos Trigeorgis (University of Cyprus) has been a leading name in academic real options for many years, publishing several influential books and academic articles in the field. He has also broadened exposure to real options through layman articles in publications such as The Wall Street Journal[2]. An academic conference on real options is organized yearly (Annual International Conference on Real Options).

Amongst others, the concept was "popularized" by Michael J. Mauboussin, the chief U.S. investment strategist for Credit Suisse First Boston and an adjunct professor of finance at the Columbia Business School. Mauboussin uses real options in part to explain the gap between how the stock market prices some businesses and the "intrinsic value" for those businesses as calculated by traditional financial analysis, specifically using discounted cash flows. This popularization is such that ROA is now a standard offering in postgraduate finance degrees, and often, even in MBA curricula at many Business Schools.

Recently, in business strategy, real options have been deployed in the construction of an "option space", where volatility is compared with value-to-cost.

[edit] Books

  • Amram, Martha; Kulatilaka,Nalin (1999). Real Options: Managing Strategic Investment in an Uncertain World. Boston: Harvard Business School Press. ISBN 0-87584-845-1. 
  • Copeland, Thomas E.; Vladimir Antikarov (2001). Real Options: A Practitioner's Guide. New York: Texere. ISBN 1-587-99028-8. 
  • Dixit, A.; R. Pindyck (1994). Investment Under Uncertainty. Princeton: Princeton University Press. ISBN 0-691-03410-9. 
  • Moore, William T. (2001). Real Options and Option-embedded Securities. New York: John Wiley & Sons. ISBN 0-471-21659-3. 
  • Müller, Jürgen (2000). Real Option Valuation in Service Industries. Wiesbaden: Deutscher Universitäts-Verlag. ISBN 3-824-47138-8. 
  • Smit, T.J.; Trigeorgis, Lenos (2004). Strategic Investment: Real Options and Games. Princeton: Princeton University Press. ISBN 0-691-01039-0. 
  • Trigeorgis, Lenos (1996). Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge: The MIT Press. ISBN 0-262-20102-X. 

[edit] See also

[edit] References

  1. ^ Campbell, R. Harvey. "Identifying real options" , Duke University, 2002.
  2. ^ http://sloanreview.mit.edu/business-insight/articles/2007/4/49410/stay-loose/

[edit] External links

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