Real Option

What is a 'Real Option'

A real option is an alternative or choice that becomes available with a business investment opportunity. Real options can include opportunities to expand and cease projects if certain conditions arise, amongst other options. They are referred to as "real" because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. Taking into account real options can greatly affect the valuation of potential investments. Oftentimes, however, valuation methods, such as NPV, do not include the benefits that real options provide.

BREAKING DOWN 'Real Option'

Note that this kind of option is not a derivative instrument, but an actual option (in the sense of "choice") that a business may gain by undertaking certain endeavors. For example, by investing in a particular project, a company may have the real option of expanding, downsizing or abandoning other projects in the future. Other examples of real options may be opportunities for R&D, M&A and licensing.

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