Real Options Reasoning as a Tool for Managerial Decision Making

Real Options Reasoning as a Tool for Managerial Decision Making

Bernadette Power (University College Cork, Ireland)
Copyright: © 2008 |Pages: 10
DOI: 10.4018/978-1-59904-843-7.ch086
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An understanding of human decision making is a fundamental step toward the development of effective intelligent decision support systems (Newell & Simon, 1972; Pomerol, 1997). Many methods have been put forth by decision theory to provide us with an understanding of human decision making and to enable individuals to make better decisions such as in utility maximization (Savage, 1954), satisficing (Simon, 1983), statistical and regression analysis, case-based reasoning (Gilboa and Schmeidler, 1995, 2000), game theory (von Neumann & Morgenstern, 1947), decision trees (Yuan & Shaw, 1995), and so forth. This article focuses on a new approach, namely, real options analysis, as a tool for effective decision making by management when faced with uncertainty in its environment.

Key Terms in this Chapter

Real Options: The owners of real options have the right, but not the obligation, to expand or contract their investment in a real asset (i.e., physical things rather than financial contracts) at some future date when uncertainties exist regarding the future value of the real asset has been resolved. Strategic investment and budget decisions within any organisation are decisions to acquire, exercise (e.g., expand, contract, or switch), abandon (e.g., temporarily or permanently), or let expire real options. The ability to delay the decision to invest introduces flexibility into this financial instrument.

Irreversibility: Irreversibility signifies the inability to costlessly revisit an investment or decision. When investments are either partially or completely irreversible, the initial cost of investment is partially unrecoverable at least. Irreversibility can be permanent if the initial state is never regained, or temporary if the initial state is returned after some time.

Option to Expand or Contract (Switching Option): An option to reallocate or switch resources has value. This is equivalent to the firm holding a portfolio of call and put options. Restarting operations when a project is currently shut down is a call option. Shutting down a project that is currently in operation is a put option, for example, using updatable computer systems to limit the cost of new technologies.

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 net present value projects in the future (e.g., growth options). Earlier investments may have created opportunities to pursue valuable follow-on projects. Management retains the right to exercise only those projects that appear to be profitable at the time of initiation.

Option: An option is a right, but not an obligation, to buy or sell a specified asset (e.g., stock, some commodity, or foreign exchange) at a prespecified price (or the exercise price) on a specified date (the expiry date). Call options (or options to buy) and put options (or options to sell) are familiar examples of contracts that allow investors to hold a choice open at the risk of losing only the small investment made to purchase the option. The ability to delay the decision about whether to buy or not to buy an asset until the maturity date of the option introduces flexibility into this financial instrument. By the time the maturity date arrives, uncertainties regarding the true value of the asset may be resolved.

Abandonment Options: The firm may have the option to cease a project during its life. This option is known as an abandonment or termination option. It is the right to sell the cash flows over the remainder of the project’s life for some salvage value.

Net Present Value (NPV): The discounted cash flow method discounts future cash flows to obtain the net present value of a project. The net present value can be calculated as follows:, where i= 1,….N is an index of the N stages in the project, t is the time at which all future cash flows become zero, CFit is the cash flow at time t given that stage i is at the end of the stage and r is the discount rate for cash flows. If the NPV > 0, then the project should be undertaken, otherwise the project should be abandoned.

Embedded Options: Embedded options are also referred to as compound options and involve a series of real options or nested investments (e.g., investments in new technological innovations, geographic markets, etc.) as opposed to making a single lump-sum investment. They can no longer be treated as independent investments but rather as links in a chain of interrelated projects, the earlier of which are prerequisites for the ones to follow. An initial foothold investment confers privileged access to information and opportunities for future investments. Each stage completed gives the firm an option to complete the next stage (e.g., expand or scale up projects) but the firm is not obliged to do so (e.g., abandonment options). The investment problem essentially boils down to discovering a contingency plan for making these sequential (and irreversible) expenditures.

Uncertainty: When the outcomes of investments cannot be estimated in the initial stages, there is uncertainty in the economic environment. Two forms of uncertainty exist, namely, market uncertainty and technical uncertainty. Market uncertainty is exogenous to the investor (e.g., firm) and correlated with economic fundamentals. Technical uncertainty is endogenous and depends on the level of initial investment made. Uncertainty is dynamically evolving and thus affects the evolution of the value of the option through time.

Flexibility: Flexibility arises from the expected added value that the firm can generate from revising its strategy over time. Strategic flexibility reflects how the firm situates itself to avail of future opportunities, challenges, new game plans, or real options.

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