The Real Options approach to investment decision making.

Essay by pugsportUniversity, Bachelor'sB-, April 2003

download word file, 6 pages 3.0

1. Real Options

Real-options analysis is one of the most important ideas of applied corporate finance to be developed in the last 30 years. Real-options analysis gives management the flexibility to address uncertainties, as they're resolved. Conventional capital budgeting fails to account for this flexibility and, moreover, fails to integrate strategic planning. But the real-options methodology goes beyond a simple view of valuation and more closely matches the manner in which businesses operate. Once a project begins, a manager has the choice to defer additional work, abandon it outright, shut it down and restart later, expand it, trim it back, or even switch its strategic purpose.

The real-options method has been used in industries like natural resources, energy, and pharmaceuticals, which have a higher degree of uncertainty in business-process investments. For example, in the oil-drilling industry, uncertainties include issues such as what the cost of the leased land will be.

How large are the oil reserves? What is the proper price for the lease on the reserve? Questions like these have led to the use of the real-options methodology as an analytical tool to evaluate these investments in business technology.

Real options offer another valuable comparison with financial investing: that holding a diverse portfolio of stocks is less risky than owning one stock. Applying this view of offsetting risk to asset/project evaluation allows for the integration of capital budgeting issues with physical assets on the one hand, and the incorporation of decision-tree analysis on the other. Real assets can be evaluated using techniques developed for financial options, such as the Black and Scholes model.

2. NPV Method

The Net Present Value (NPV) has been one of the most common methods used in making investment appraisals. Most financial managers are familiar with the NPV method, which is based on expected cash...