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Topic: - What are the four main types of real options? Explain the
implications of real options in case of analyzing the project.
PGP/SS/08-10/B
Real options are methods which quantify the value of management flexibility
in the uncertainty prevailing world. These options are said to be the strategic
options. They adapt to the decisions wherein they have to response to
uncertainty or unexpected market developments. Conceptually saying, Real
Options allows the management to determine and communicate the
strategic value of the project wherein investments have been made.
Traditional Methods like NPV etc. sometimes fails to determine the economic
value on investments in such an environment where there is huge
uncertainty and rapid change, and that is where Real Options are useful.
Identifying, managing and exercising Real Options can also be used for
creating the shareholders value which is compounded by their investment
portfolio. The real options method represents the new state-of-the-art
technique for the valuation and management of strategic investments. The
real option method enables corporate decision-makers to leverage
uncertainty and limit downside risk. A firm has always one or more options to
take strategic decisions during lifespan of a project. For example, a natural
resource firm can take decision to not extract the gold from the mine if the
price of the gold falls below the cost of extraction and vice versa. These
strategic options, which are known as real options, are typically ignored in
standard discounted cash flow (DCF) analysis where a single expected
present value is computed. These real options, however, can significantly
increase the value of a project by eliminating unfavorable outcomes
3) Growth Options
4) Flexibility Options
Example:
When there is more uncertainty about the future cash flows and this
increased uncertainty makes the firm more or less willing to invest in
the project today, this is investment timing options. This option talks
about the time of the investment of the project whether it right time to
invest or not.
These are the following questions which one may ask in the option
What is the expected NPV of Project X if any firm waits 6 and half
months to decide whether to undertake the project?
3) Growth Options
The value of the firm can exceed the market value of the projects
currently in place because the firm may have the opportunity to
undertake positive NPV projects in the future. Standard capital
budgeting techniques involve establishing the present value of these
IIPM, Ahmedabad Page 4
projects based on anticipated implementation dates. However, this
implicitly assumes that the firm is committed to go ahead with the
projects. Since management need not make such a commitment, they
retain the option to exercise only those projects that appear to be
profitable at the time of initiation. The value of these options should be
considered in valuing the firm. Growth options are particularly valuable
in infrastructure-based or strategic industries. For example, in the high-
tech and software industries (where there are significant first-mover
advantages) valuable growth options can be obtained through R&D
expenditure and by creating strategic links with other industry players
-- even though these activities may appear to be negative NPV
investments when viewed in isolation.
Four silver production sites, each with different layout and extraction
technologies.
The price of silver has been very volatile. To value firm based upon
forecasts of silver prices (traditional NPV approach) could grossly
underestimate the value.
Strategic Considerations/Options
This explains why private or small firms, which have far less access to
capital, will value financial flexibility more than larger firms. The existence of
corporate bond markets can also make a difference in how much flexibility is
valued. In markets where firms cannot issue bonds and have to depend
entirely upon banks for financing, there is less access to capital and a greater
need to maintain financial flexibility.
Conclusion