Real Options

Real options refer an alternative or choice that becomes available with a business investment opportunity. The real options valuation or analysis is described as a decision-making framework that calculates the value of a future business decision. Real options branch from the financial options theory. The financial option refers to the state where the buyer of a financial asset has the right to purchase a stock or bond, for example, at a predetermined price at a future date.

Real options help a company in capturing the value of managerial flexibility to adapt decisions in response to unexpected market developments. Real options are not derivative instruments but an actual option that a business may gain by undertaking certain endeavors. Let us assume that by investing in a particular project, a company may have the real option of expanding, downsizing, or abandoning other projects in the future. Some of the other examples of real options may be opportunities for R&D, M&A, and licensing.

Real options are termed as ‘real’ because they usually pertain to tangible assets, such as capital equipment, rather than financial instruments. The traditional methods like net present value often fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change. This method of real options represents the new state-of-the-art technique for the valuation and management of strategic investments. The real option method helps and enables corporate decision-makers to leverage uncertainty and limit downside risk.

Real option analysis is an effective tool and method that can provide real value in business scenarios when data is sparse or outcomes highly uncertain. The main advantage of real option analysis is the robust analytical tools it borrows from the financial markets, which can greatly enhance the information available for decision-making.

Questions:

• What are real options?
• How are real options essential in a firm?