What is a 'Real Option'

A real option is a choice made available with business investment opportunities, referred to as “real” because it typically references a tangible asset instead of 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 impacts 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.

BREAKING DOWN 'Real Option'

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 of the real option value the facility provides. Other examples of real options include possibilities for mergers and acquisitions (M&A) or joint ventures.

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.

Understanding the Basis of Real Options Reasoning

Real options reasoning is 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.

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.

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