Real options valuation

In corporate finance, real options analysis applies put option and call option valuation techniques to capital budgeting decisions.

A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. For example, the opportunity to invest in the expansion of a firm's factory is a real option. In contrast to financial options a real option is not tradeable—e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision. The terminology "real option" is relatively new, whereas business operators have been making capital investment decisions for centuries. However the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such the terminology "real option" is closely tied to these new methods. The term "real option" was coined by Professor Stewart Myers at the MIT Sloan School of Management.

Additionally, 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. More importantly, the real options approach forces decision makers to be more explicit about the assumptions underlying their projections.

Generally, the most widely used methods are: Closed form solutions, partial differential equations and the binomial lattices. In business strategy, Real Options have been advanced by the construction of option space, where volatility is compared with value-to-cost, NPVq.

See also

• Option
• Black-Scholes

External links

• Applications of option pricing theory to equity valuation Prof. Aswath Damodaran, Stern School of Business
• How Do You Assess The Value of A Company's "Real Options"?, Prof. Alfred Rappaport Columbia University and Michael Mauboussin
• Real Options Tutorial, Prof. Marco Dias, PUC-Rio
• Real Options Selected Links, Prof. Marco Dias, PUC-Rio
• Applying Options Theories to Technology Management Decisions, CTO Network Library, 2005.
• Real Options Links and Resources at MoneyScience
• Strategic Technology Investment Decisions in Research & Development David Lackner MIT Lean Advancement Initiative
• IBM paper on real options analysis
• Real Options Books, a slightly outdated but useful list of books on real options