What Is a Real Option?

A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. It is referred to as “real” because it typically references projects involving a tangible asset (such as machinery, land, and buildings, as well as inventory), instead of a financi🥃al instrument.

Real options thus differ from financial 澳洲幸运5官方开奖结果体彩网:options contracts since they involve real (i.e., physical) 澳洲幸运5官方开奖结果体彩网:underlying assets and are not exchangeable as securities.

Understanding Real Options

Real options are choices that a company’s management gives itself the option to make, in order 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 use🃏d valuations fail to account for potential benefits provided by real options.

Using real options value (ROV) analysis, managers can estimate the 澳洲幸运5官方开奖结果体彩网:opportunity cost of cont🌠inuing or abandoning a project and make better d♉ecisions accordingly.

It is important to note that real options do not refer to a derivative financial instrument, such as call and put options contracts, which give the holder the right to 🃏buy or sell an underlying asset, respectively. Instead, real options are opportunities that a business may or may not take advantage of or realize.

For example, investing in a new manufacturing facility may provide a company with real options for introducing new products, consolidating operations, or making other adjustments in response to changing market conditions. When deciding whether to invest in the new facility, the company should consider the real option value that the facility provides. Other examples of real options include possibilities for 澳洲幸运5官方开奖结果体彩网:mergers and acquisitions (M&A) or 澳洲幸运5官方开奖结果体彩网:joint ventures.

Real Options Valuation

The precise value of real options can be difficult to establish or estimate. F🅺or instance, 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 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 the potential for real option value into the decision-making process, even though the value is necessarily somewhat vague and uncertain. Of course, the key difference between real options and derivatives contracts is that the latter often trades on an exchange and has a numerical value in terms of its price or premium. Real options, on the other hand, are far more subjective. By using a combination of experience, and financial valuations, however, management should get some sense of the value of the project being consider𓄧ed and whether it’s worth the risk.

Still, valuation techniques for real options often appear similar to the pricing of financial options contracts, where the spot price or the current market price refers to the current 澳洲幸运5官方开奖结果体彩网:net present value (NPV) of a project. The net present value is the cash flow that’s expected as a result of the new project, but those flows are discounted by a rate that could otherwise be earned for doing nothing. The alternative rate or 澳洲幸运5官方开奖结果体彩网:discount rate might be the rate of♍ a U.S. Treasury bond, for example. If Treasuries pay 3%, then the project or the cash flows must yield a return of more than 3%;🎀 otherwise, it wouldn’t be worth pursuing.

Some valuation models use terminology from 澳洲幸运5官方开奖结果体彩网:derivatives markets wherein the 澳洲幸运5官方开奖结果体彩网:strike price corresponds to non-recoverable costs involved with the project. In the derivatives world, the strike would be the price at which the option🥀s contract converts into the underlying security that it is based on.

Similarly, the 澳洲幸运5官方开奖结果体彩网:expiration date of an options contract could be substituted with the time frame within which the business decision should be made. Options contracts also have a 澳洲幸运5官方开奖结果体彩网:volatility component, which measures the level of risk in an investment. The higher the risk, the more expensive the option. Real options must also consider the risk💃 involved, and it too could be𝔉 assigned a value similar to volatility.

Other methods of valuing real options include 澳洲幸运5官方开奖结果体彩网:Monte Carlo simulations, which u൲se mathematical calculꦇations to assign probabilities to various outcomes given certain variables and risks.

Special Considerations

Heuristic Reasoning

Real options analysis is still often considered to be a 澳洲幸运5官方开奖结果体彩网:heuristic—a rule of thumb, allowing for flexibility an꧙d quick decision making in a complex, ever-changing environment—based on sound financi𝔉al criteria. The real options heuristic is simply the recognition of the value embodied in the flexibility of choosing among alternatives although their objective values cannot be mathematically determined with any degree of certainty.

Even if a quantitative model is employed to value a real option, the choice of the mode🎃l itself is based on judgment and often a trial-and-error approach since the choices♛ available can vary across firms and project managers.

Having 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 ౠconditions.

In short, real options are about companies making decisions and choices that grant them the greꩵatest amount of flexibili💮ty and potential benefit regarding possible future decisions or choices.

Choices That Fall Under Real Options

The choices that corporate managers face that typically fall under real options analysis are under three categories of 澳洲幸运5官方开奖结果体彩网:project management.

1. The first group is options relating to the size of a project. Depending on the ROV analysis, options may exist to expand, contract, or expand and contract the project over time, given various contingencies.
2. The 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.
3. The third group of real options involves the project’s operations: the process flexibility, product mix, and operating scale, among others.

Real options are most appropriate when the economic environment and market conditions relating to a particular project aꦆre highly volatile yet flexible. Stable꧒ 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.

Real-World Example of Real Options

McDonald’s Corp. (MCD) has restaurants in more than 100 countries. Let’s say the company’s executives ar👍e mulling the decision to open additional restaurants in Russia. The expansion would fall under the category of real option to expand. The investment or capital outlay would need to be calculated, including the c♊ost of the physical buildings, land, staff, and equipment.

However, McDonald’s executives would need to decide if the revenu𒐪e earned from the new restaurants will be enough to counter any potential country and political risk, which is difficult 🌠to value.

The same scenario could also produce a real option to wait or de𓆉fer opening any restaurants until a particular political situation resolves itself. Perhaps there’s an upcoming election, and the result could impact the stability of the country or the regulatory environment.

The Bottom Line

A real option gives management of a company the right, but not the obligation, to undertake certain business opportunities or investments. It is called a real option because it usually references projects involving a tangible asset (such as machinery, land, and buildings, as well as inventory), instead of a financial instrument.