Real options valuation - Wikipedia

Terms of real options

Types of real options[ edit ] Simple Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from "Investment Example". Consider a firm that has the option to invest in a new factory.

Thinking in terms of real options

It can invest this year or next year. The question is: when should the firm invest? If the firm invests this year, it has an income stream earlier. But, if it invests next year, the firm obtains further information about the state of the economy, which can prevent it from investing with losses. The firm knows its discounted cash flows if it invests this year: 5M.

A Gardening Metaphor: Options as Tomatoes

If it invests next year, the discounted cash flows are 6M with a The investment cost is 4M. If the firm invests next year, the present value of the investment cost is 3.

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Following the net present value rule for investment, the firm should invest this year because the discounted cash flows 5M are greater than the investment costs 4M by 1M. Yet, if the firm waits for next year, it only invests if discounted cash flows do not decrease.

If discounted cash flows decrease to 3M, then investment is no longer profitable. If, they definitions of options to 6M, then the firm invests.

The real power of real options

This implies that the firm invests next year with a Thus the value to invest next year is 1. Given that the value to invest next year exceeds the value to invest this year, the firm should wait for further information to prevent losses. This simple example shows how the net present value may lead the firm to take unnecessary risk, which could be prevented by real options valuation.

Staged Investment Staged investments are quite often in the pharmaceutical, mineral, and oil industries.

Why real options are important

In this example, it is studied a staged investment abroad in which a firm decides whether to open one or two stores in a foreign country. This is adapted from "Staged Investment Example".

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The firm does not know how well its stores are accepted in a foreign country. If their stores have high demand, the discounted cash flows per store is 10M.

Strategy as a Portfolio of Real Options

If their stores have low demand, the discounted cash flows per store is 5M. It is also known that if the store's demand is independent of the store: if one store has high demand, the other also has high demand.

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The terms of real options cost per store is 8M. Should the firm invest in one store, two stores, or not invest? The net present value suggests the firm should not invest: the net present value is But is it the best terms of real options Following real options valuation, it is not: the firm has the real option to open one store this year, wait a year to know its demand, and invest in the new store next year if demand is high.

The value trading with the trend in the stock market open one store this year is 7.

Thus the value of the real option to invest in one store, wait a year, and invest next year is 0.

Given this, the firm should opt by opening one store. This simple example shows that a negative net present value does not imply that the firm should not invest. Options relating to project size[ edit ] Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality. A project with the option to expand will cost more to establish, the excess being the option premiumbut is worth more than the same without the possibility of expansion.

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This is equivalent to a call option. Option to contract : The project is engineered such that output can be contracted in future should conditions turn out to be unfavourable. Forgoing these future expenditures constitutes option exercise. This is the equivalent to a put optionand again, the excess upfront expenditure is the option premium.

Option to expand or contract: Here the project is designed such that its operation can be dynamically turned on and off. Management may shut down part or all of the operation when conditions are unfavorable a put optionand may restart operations when conditions improve a call option. A flexible manufacturing system FMS is a good example of this type of option. This option is also known as a Switching option.

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Options relating to project life and terms of real options edit ] 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.

Initiation or deferment options: Here management has flexibility as to when to start a project. For example, in natural resource exploration a firm can delay mining a deposit until market conditions are favorable. This constitutes an American styled call option.

Delay option with a product patent: A firm with a patent right on a product has a right to develop and market the product exclusively until the expiration of the patent. The firm will market and develop the product only if the present value of the expected cash flows from the product sales exceeds the cost of development.

A Tour of Option Space

If this does not occur, the firm can shelve the patent and not incur any further costs. Option to abandon: Management may have the option to cease a project during its life, and, possibly, to realise its salvage value. Here, when the present value of the remaining cash flows falls below the liquidation value, the asset may be sold, and this act is effectively the exercising of a put option.

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This option is also known as a Termination option. Abandonment options are American styled. Sequencing options: This option is related to the initiation option above, although entails flexibility as to the timing of more than one inter-related projects: the analysis terms of real options is as to whether it is advantageous to implement these sequentially or in parallel.

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Here, observing the outcomes relating to the first project, the firm can resolve some of the uncertainty relating to the venture overall. Once resolved, management has the option to proceed or terms of real options with the development of the other projects.