• This involves estimating what the asset’s value would be if it existed today and forecasting to see the full set of possible future values… [These] calculations provide
  you with numbers for all the possible future values of the option at the various points where a decision is needed on whether to continue with the project…[30] When valuing the real option, the analyst must therefore consider the inputs
  to the valuation, the valuation method employed, and whether any technical limitations may apply.

• [20][30][31][34] The specific application, though, is as follows: • The option’s underlying is the project in question – it is modelled in terms of: o Spot price: the starting
  or current value of the project is required: this is usually based on management’s “best guess” as to the gross value of the project’s cash flows and resultant NPV; o Volatility: a measure for uncertainty as to the change in value over time
  is required:  the volatility in project value is generally used, usually derived via monte carlo simulation;[31][35] sometimes the volatility of the first period’s cash flows are preferred;[32] see further under Corporate finance for a discussion
  relating to the estimation of NPV and project volatility.

• Example methods include real options analysis based on decision rules,[48][49] which merge physical design considerations and management decisions through an intuitive “if-then-else”
  statement e.g., if demand is higher than a certain production capacity level, then expand existing capacity, else do nothing.

• 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.

• 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”..

• These options are particularly valuable in industries where demand is volatile or where quantities demanded in total for a particular good are typically low, and management
  would wish to change to a different product quickly if required.

• [3] These typically use cash-flow scenarios for the projection of the future pay-off distribution, and are not based on restricting assumptions similar to those that underlie
  the closed form (or even numeric) solutions discussed.

• Valuation Given the above, it is clear that there is an analogy between real options and financial options,[20] and we would therefore expect options-based modelling and analysis
  to be applied here.

• Management’s ability to respond to changes in value is modeled at each decision point as a series of options, as above these may comprise, i.a.

• The methods help rank order flexible design solutions relative to one another, and thus enable the best real option strategies to be exercised cost effectively during operations.

• Given these different treatments, the real options value of a project is typically higher than the NPV – and the difference will be most marked in projects with major flexibility,
  contingency, and volatility.

• [28]) Part of the criticism (and subsequently slow adoption) of Real Options Valuation in practice and academe stems from the generally higher values for underlying assets
  these functions generate.

• [13][14][15] This extension of real options to real-world projects often requires customized decision support systems, because otherwise the complex compound real options
  will become too intractable to handle.

• [29] Options based valuation[edit] Although there is much similarity between the modelling of real options and financial options,[20][30] ROV is distinguished from the latter,
  in that it takes into account uncertainty about the future evolution of the parameters that determine the value of the project, coupled with management’s ability to respond to the evolution of these parameters.

• the option would be in the money) given that the present value of expected cash flows exceeds this amount; o Option term: the time during which management may decide to act,
  or not act, corresponds to the life of the option.

• [36][37] Note though that, in general, while most “real” problems allow for American style exercise at any point (many points) in the project’s life and are impacted by multiple
  underlying variables, the standard methods are limited either with regard to dimensionality, to early exercise, or to both.

• Here, only the expected cash flows are considered, and the “flexibility” to alter corporate strategy in view of actual market realizations is “ignored”; see below as well
  as Corporate finance § Valuing flexibility.

• Real options are most valuable when uncertainty is high; management has significant flexibility to change the course of the project in a favorable direction and is willing
  to exercise the options.

• Real options are also commonly applied to stock valuation – see Business valuation § Option pricing approaches – as well as to various other “Applications” referenced below.

• • Operating scale options: Management may have the option to change the output rate per unit of time or to change the total length of production run time, for example in response
  to market conditions.

• Just as terms of business are affected by external environmental factors, these same circumstances affect the volatility of returns, as well as the discount rate (as firm
  or project specific risk).

• A more recent approach reformulates the real option problem as a data-driven Markov decision process,[50][51] and uses advanced machine learning like deep reinforcement learning
  to evaluate a wide range of possible real option and design implementation strategies, well suited for complex systems and investment projects.

• [6] Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed
  for financial options to “real-life” decisions.

• For example, R&D managers can use Real Options Valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects.

• management, can directly influence the value of the option’s underlying project; whereas this is not a consideration as regards the underlying security of a financial option.

• for natural resources, price and quantity — some analysts attempt to use an overall volatility; this, though, is more correctly treated as a rainbow option,[32] typically
  valued using simulation as below.)

• In selecting a model, therefore, analysts must make a trade off between these considerations; see Option (finance) § Model implementation.

• First, you must figure out the full range of possible values for the underlying asset….

• The theoretical issues: • To use standard option pricing models here, despite the difficulties relating to rational pricing, practitioners adopt the “fiction” that the real
  option and the underlying project are both traded: the so called, Marketed Asset Disclaimer (MAD) approach.

• Market characteristics[edit] As discussed above, the market and environment underlying the project must be one where “change is most evident”, and the “source, trends and
  evolution” in product demand and supply, create the “flexibility, contingency, and volatility” [27] which result in optionality.

• Under ROV, however: (a) managements’ actions actually change the risk characteristics of the project in question, and hence (b) the Required rate of return could differ depending
  on what state was realised, and a premium over risk free would be required, invalidating (technically) the risk neutrality assumption.

• The contingent nature of future profits in real option models is captured by employing the techniques developed for financial options in the literature on contingent claims
  analysis.

• Prototyping can hedge these risks by spending a fraction of the cost of a full-scale system and in return receiving economic and technical information regarding the system.

• Then, (b) since the cash flows of the option and the portfolio will always be identical, by arbitrage arguments their values may (must) be equated today, and (c) no discounting
  is required.

• (An application of Real Options Valuation in the Philippine banking industry exhibited that increased levels of income volatility may adversely affect option values on the
  loan portfolio, when the presence of information asymmetry is considered.

• Finally, even if the firm can actively adapt to market changes, it remains to determine the right paradigm to discount future claims The difficulties, are then: 1.

• Technical considerations[edit] Limitations as to the use of these models arise due to the contrast between Real Options and financial options, for which these were originally
  developed.

• As in the preceding cases, this flexibility increases the value of the project, corresponding in turn, to the “premium” paid for the real option.

• • Standard option models: (a) Assume that the risk characteristics of the underlying do not change over the life of the option, usually expressed via a constant volatility
  assumption.

• [52] Limitations The relevance of Real options, even as a thought framework, may be limited due to market, organizational and / or technical considerations.

• [3] For example, real options valuation could examine the opportunity to invest in the expansion of a firm’s factory and the alternative option to sell the factory.

• deterministic — costs: in cases where the project’s costs, like its revenue, are also assumed stochastic, then Margrabe’s formula can (should) be applied instead,[38][39]
  here valuing the option to “exchange” expenses for revenue.

• Growth options are perhaps the most generic in this category – these entail the option to exercise only those projects that appear to be profitable at the time of initiation.

• In economic terms, prototyping is an option to hedge risk coming at a cost that needs to be properly assessed.

• This simple example shows that a negative net present value does not imply that the firm should not invest.

• Unlike financial options, management also have to create or discover real options, and such creation and discovery process comprises an entrepreneurial or business task.

• Management must be in the position to exercise, in so far as some real options are proprietary (owned or exercisable by a single individual or a company) while others are
  shared (can (only) be exercised by many parties).

• The financial position of the business must be such that it has the ability to fund the project as, and when, required (i.e.

• Here, since the value or price of the underlying cannot be (directly) observed, there will always be some (much) uncertainty as to its value (i.e.

• [30] • To address the fact that changing characteristics invalidate the use of a constant discount rate, some analysts use the “replicating portfolio approach”, as opposed
  to Risk neutral valuation, and modify their models correspondingly.

• Organizational considerations[edit] Real options are “particularly important for businesses with a few key characteristics”,[27] and may be less relevant otherwise.

• If taken in parallel, management would have already spent the resources and the value of the option not to spend them is lost.

• See Option time value.

• :  the option to contract the project (an American styled put option);  the option to abandon the project (also an American put);  the option to expand or extend the project
  (both American styled call options);  switching options or composite options which may also apply to the project.

• 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.

• [2] Under this “standard” NPV approach, future expected cash flows are present valued under the empirical probability measure at a discount rate that reflects the embedded
  risk in the project; see CAPM, APT, WACC.

• The description of such opportunities as “real options”, however, followed on the development of analytical techniques for financial options, such as Black–Scholes in 1973.

• Further, a project may have a portfolio of embedded real options, some of which may be mutually exclusive.

• 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.

• issue shares, absorb further debt and / or use internally generated cash flow); see Financial statement analysis.

• (d) Under ROV however,[34] the option and (usually) its underlying are clearly not traded, and forming a hedging portfolio would be difficult, if not impossible.

• [21] [22] [23] Even when employed, however, these latter methods do not normally properly account for changes in risk over the project’s lifecycle and hence fail to appropriately
  adapt the risk adjustment.

• Real options consider “all” scenarios (or “states”) and indicate the best corporate action in each of these contingent events.

• • 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
  here is as to whether it is advantageous to implement these sequentially or in parallel.

• [4] Real options are generally distinguished from conventional financial options in that they are not typically traded as securities, and do not usually involve decisions
  on an underlying asset that is traded as a financial security.

• As such, the term “real option” is closely tied to these option methods.

• Even where a market exists – for the underlying or for the option – in most cases there is limited (or no) market liquidity.

• [30][39] Under this approach, (a) we “replicate” the cash flows on the option by holding a risk free bond and the underlying in the correct proportions.

• [40] Note that for American styled real options, this application is somewhat more complex; although recent research[41] combines a least squares approach with simulation,
  allowing for the valuation of real options which are both multidimensional and American styled; see Monte Carlo methods for option pricing § Least Square Monte Carlo.

 

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Photo credit: https://www.flickr.com/photos/garlandcannon/6936225976/’]