What is a Real Option
A real option is a choice made available to the managers of a company with respect to business investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset instead of a financial instrument. Real options are choices a company’s management makes to expand, change or curtail projects based on changing economic, technological or market conditions. Factoring in real options affects the valuation of potential investments, although commonly used valuations, such as net present value (NPV), fail to account for potential benefits provided by real options. Using real options value analysis (ROV), managers can estimate the opportunity cost of continuing or abandoning a project and make decisions accordingly.
Real options do not refer to a derivative financial instrument, but to actual choices or opportunities of which a business may take advantage or may realize. For example, investing in a new manufacturing facility may provide a company with real options of introducing new products, consolidating operations or making other adjustments to changing market conditions. In the course of making the decision to invest in the new facility, the company should consider the real option value the facility provides. Other examples of real options include possibilities for mergers and acquisitions (M&A) or joint ventures.
BREAKING DOWN Real Option
The precise value of real options can be difficult to establish or estimate. Real option value may be realized from a company undertaking socially responsible projects, such as building a community center. By doing so, the company may realize a goodwill benefit that makes it easier to obtain necessary permits or approval for other projects. However, it’s difficult to pin an exact financial value on such benefits. In dealing with such real options, a company’s management team factors potential real option value into the decision-making process, even though the value is necessarily somewhat vague and uncertain.
Still, valuation techniques for real options do often appear similar to the pricing of financial options contracts, where the spot price refers to the current net-present value of a project, while the strike price corresponds to non-recoverable costs involved with the project. The most common method of valuing real options currently is a form of binomial tree following a latticed (flexible) model. Monte Carlo simulations are also often used in the evaluation of real options.
Understanding the Basis of Real Options Reasoning
Real options analysis is still often a heuristic – a rule of thumb allowing for flexibility and quick decisions in a complex, ever-changing environment – based on logical financial choices. The real options heuristic is simply the recognition of the value of flexibility and alternatives despite the fact that their value cannot be mathematically quantified with any certainty. Even if a quantitative model is employed to value a real option, the choice of the model itself is a heuristic because this choice will vary across firms and across project managers.
Thus, real options reasoning is based on logical financial options in the sense that those financial options create a certain amount of valuable flexibility. Having financial options affords the freedom to make optimal choices in decisions, such as when and where to make a specific capital expenditure. Various management choices to make investments can give companies real options to take additional actions in the future, based on existing market conditions.
In short, real options are about companies making decisions and choices that grant them the greatest amount of flexibility and potential benefit in regard to possible future decisions or choices.
Choices Falling Under Real Options
The choices that corporate managers face that typically fall under real options analysis are under three categories of project management. The first group are options relating to the size of a project. Depending on the ROV analysis, options may exist to expand, contract or, in some cases, expand AND contract the project over time, given various contingencies. A second group relates to the lifetime of a project - to initiate one, delay starting one, abandon an existing one, or plan the sequencing of the project's steps. A third group of real options deals with the project's operations: the process flexibility, product mix and operating scale, among others.
Real options are most appropriate when the environment and market conditions relating to a particular project are highly volatile and flexible. Stable or rigid environments will not benefit much from ROV and should use more traditional corporate finance techniques instead. Similarly, ROV is applicable only when a firm's corporate strategy lends itself to flexibility, has sufficient information flow and has sufficient funds to cover potential downside risks associated with real options.