Real options valuation

Real options valuation, also often termed real options analysis, (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively.This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from 'Investment Example'..mw-parser-output cite.citation{font-style:inherit}.mw-parser-output .citation q{quotes:''''''''''''}.mw-parser-output .citation .cs1-lock-free a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/6/65/Lock-green.svg/9px-Lock-green.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output .citation .cs1-lock-limited a,.mw-parser-output .citation .cs1-lock-registration a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/d/d6/Lock-gray-alt-2.svg/9px-Lock-gray-alt-2.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output .citation .cs1-lock-subscription a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/a/aa/Lock-red-alt-2.svg/9px-Lock-red-alt-2.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output .cs1-subscription,.mw-parser-output .cs1-registration{color:#555}.mw-parser-output .cs1-subscription span,.mw-parser-output .cs1-registration span{border-bottom:1px dotted;cursor:help}.mw-parser-output .cs1-ws-icon a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/4/4c/Wikisource-logo.svg/12px-Wikisource-logo.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output code.cs1-code{color:inherit;background:inherit;border:inherit;padding:inherit}.mw-parser-output .cs1-hidden-error{display:none;font-size:100%}.mw-parser-output .cs1-visible-error{font-size:100%}.mw-parser-output .cs1-maint{display:none;color:#33aa33;margin-left:0.3em}.mw-parser-output .cs1-subscription,.mw-parser-output .cs1-registration,.mw-parser-output .cs1-format{font-size:95%}.mw-parser-output .cs1-kern-left,.mw-parser-output .cs1-kern-wl-left{padding-left:0.2em}.mw-parser-output .cs1-kern-right,.mw-parser-output .cs1-kern-wl-right{padding-right:0.2em}. Real options valuation, also often termed real options analysis, (ROV or ROA) applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively. Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions on an underlying asset that is traded as a financial security. A further distinction is that option holders here, i.e. management, can directly influence the value of the option's underlying project; whereas this is not a consideration as regards the underlying security of a financial option. Moreover, management cannot measure uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike financial options, management also have to create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task. Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing to exercise the options. Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to 'real-life' decisions. For example, R&D managers can use Real Options Valuation to help them allocate their R&D budget among diverse projects; a non business example might be the decision to join the work force, or rather, to forgo several years of income to attend graduate school. It, thus, forces decision makers to be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business strategy formulation. This extension of real options to real-world projects often requires customized decision support systems, because otherwise the complex compound real options will become too intractable to handle. The flexibility available to management – i.e. the actual 'real options' – generically, will relate to project size, project timing, and the operation of the project once established. In all cases, any (non-recoverable) upfront expenditure related to this flexibility is the option premium. Real options are also commonly applied to stock valuation - see Business valuation #Option pricing approaches - as well as to various other 'Applications' referenced below. Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality. Where there is uncertainty as to when, and how, business or other conditions will eventuate, flexibility as to the timing of the relevant project(s) is valuable, and constitutes optionality. Growth options are perhaps the most generic in this category – these entail the option to exercise only those projects that appear to be profitable at the time of initiation. Management may have flexibility relating to the product produced and /or the process used in manufacture. This flexibility constitutes optionality. Given the above, it is clear that there is an analogy between real options and financial options, and we would therefore expect options-based modelling and analysis to be applied here. At the same time, it is nevertheless important to understand why the more standard valuation techniques may not be applicable for ROV. ROV is often contrasted with more standard techniques of capital budgeting, such as discounted cash flow (DCF) analysis / net present value (NPV). Under this 'standard' NPV approach, future expected cash flows are present valued under the empirical probability measure at a discount rate that reflects the embedded risk in the project; see CAPM, APT, WACC. Here, only the expected cash flows are considered, and the 'flexibility' to alter corporate strategy in view of actual market realizations is 'ignored'; see below as well as Corporate finance#Valuing flexibility. The NPV framework (implicitly) assumes that management is 'passive' with regard to their Capital Investment once committed. Some analysts account for this uncertainty by adjusting the discount rate, e.g. by increasing the cost of capital, or the cash flows, e.g. using certainty equivalents, or applying (subjective) 'haircuts' to the forecast numbers, or via probability-weighting as in rNPV. Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment.