Real options valuation

Real options valuation, also often termed real options analysis, (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, real options valuation could examine the opportunity to invest in the expansion of a firm's factory and the alternative option to sell the factory.

Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options.

Scope

Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security. A further distinction is that option holders here, i.e. management, can directly influence the value of the option's underlying project; whereas this is not a consideration regarding the underlying security of a financial option. Moreover, management cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike financial options, management must also create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task.

Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to "real-life" decisions. For example, R&D managers can use real options valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects. Non-business examples might be evaluating the cost of cryptocurrency mining machines, or the decision to join the work force, or rather, to forgo several years of income to attend graduate school. It, thus, forces decision makers to be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business strategy formulation. This extension of real options to real-world projects often requires customized decision support systems, because otherwise the complex compound real options will become too intractable to handle.

Types of real options

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This simple example shows the relevance of the real option to delay investment and wait for further information.

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

The firm does not know how well its stores are accepted in a foreign country. If their stores have high demand, the discounted cash flows per store is 10M. If their stores have low demand, the discounted cash flows per store is 5M. Assuming that the probability of both events is 50%, the expected discounted cash flows per store is 7.5M. 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 risk neutral rate is 10%. The investment cost per store is 8M. In all cases, any (non-recoverable) upfront expenditure related to this flexibility is the option premium. Real options are also commonly applied to stock valuation - see - as well as to various other "Applications" referenced below.

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.

Option to expand: Here the project is built with capacity in excess of the expected level of output so that it can produce at higher rates if needed. Management then has the option (but not the obligation) to expand – i.e. exercise the option – should conditions turn out to be favourable. A project with the option to expand will cost more to establish, the excess being the option premium, but 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 option, and 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 option), and 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

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.

Growth options: perhaps the most generic in this category – these entail the call option to exercise only those projects that appear to be profitable at the time of initiation.
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. Once resolved, management has the option to proceed or not with the development of the other projects. If taken in parallel, management would have already spent the resources and the value of the option not to spend them is lost. The sequencing of projects is an important issue in corporate strategy. Related here is also the notion of Intraproject vs. Interproject options.

<!-- Too specific *Option to prototype: New energy generation and storage systems are continuously being developed due to climate change, resource scarcity, and environmental laws. Some systems are incremental innovations of existing systems while others are radical innovations. Radical innovation systems are risky investments due to their relevant technical and economic uncertainties. Prototyping can hedge these risks by spending a fraction of the cost of a full-scale system and in return receiving economic and technical information regarding the system. In economic terms, prototyping is an option to hedge risk coming at a cost that needs to be properly assessed.

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Options relating to project operation

Management may have flexibility relating to the product produced and/or the process used in manufacture. As in the preceding cases, this flexibility increases the value of the project, corresponding in turn, to the "premium" paid for the real option.

Output mix options: The option to produce different outputs from the same facility is known as an output mix option or product flexibility. These options are particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good are typically low, and management would wish to change to a different product quickly if required.
Input mix options: An input mix option – process flexibility – allows management to use different inputs to produce the same output as appropriate. For example, a farmer will value the option to switch between various feed sources, preferring to use the cheapest acceptable alternative. An electric utility, for example, may have the option to switch between various fuel sources to produce electricity, and therefore a flexible plant, although more expensive may actually be more valuable.
Operating scale options: Management may have the option to change the output rate per unit of time or to change the total length of production run time, for example in response to market conditions. These options are also known as Intensity options.

Valuation

Given the above, it is clear that there is an analogy between real options and financial options, Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment.

By contrast, ROV assumes that management is "active" and can "continuously" respond to market changes. Real options consider "all" scenarios (or "states") and indicate the best corporate action in each of these contingent events. Part of the criticism and subsequently slow adoption of real options valuation in practice and academia stems from the generally higher values for underlying assets these functions generate. However, studies have shown that these models are reliable estimators of underlying asset value, when input values are properly identified.

Options based valuation

Although there is much similarity between the modelling of real options and financial options, ROV is distinguished from the latter, in that it takes into account uncertainty about the future evolution of the parameters that determine the value of the project, coupled with management's ability to respond to the evolution of these parameters. It is the combined effect of these that makes ROV technically more challenging than its alternatives.