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Real Options: a Management Approach

The process of evaluating the desirability of long-term investment proposals is referred to as “capital budgeting.” Making optimum capital budgeting decisions (e.g. whether to accept or reject a proposed project), often requires recognizing and correctly accounting for flexibilities associated with the project.


Such flexibilities are more formally termed real options. From a valuation standpoint, these options are valuable because they allow decision makers to react to favorable or unfavorable new situations by dynamically adjusting the capital budgeting decision process. Unfortunately, the value of real options is not explicitly considered in conventional procedures (such as discounted cash flow - DCF - models) used to evaluate long-term investment proposals. In some sense, therefore, real options can be viewed as an extension of DCF that incorporates a simple model of strategic learning.


Traditional discounted cash-flows method for assessing projects assumes, indeed, that investment decision is an irreversible one, which is not correct. Managers can and must reconsider their initial decision as the new information arises during the project life. This is managerial flexibility and it creates strategic value for a project, only if management takes advantage of the opportunities associated with an analyzed project. Real options represent a new approach in capital budgeting, using the theory of pricing financial options for investments in real assets.


 


Strategy is a Portfolio of Real Options [*]


In financial terms, a business strategy is much more like a series of options than like a single projected cash flow. Executing a strategy almost always involves making a sequence of major decisions. Some actions are taken immediately while others are deliberately deferred so that managers can optimize their choices as circumstances evolve. While executives readily grasp the analogy between strategy and real options, until recently the mechanics of option pricing was so complex that few companies found it practical to use when formulating strategy. But advances in both computing power and our understanding of option pricing over the last 20 years now make it feasible to apply real-options thinking to strategic decision making.


Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments. Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project. Traditional methods (e.g. net present value) fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change. The real options method represents the new state-of-the-art technique for the valuation and management of strategic investments. The real option method enables corporate decision-makers to leverage uncertainty and limit downside risk.


[*] from an article of Timothy A. Luerhman

The Essence of Real Options

The Essence of Real Options [by Aswath Damodaran]

Introduction to Real Options

Introduction to Real Options [by Aswath Damodaran]