An automated binary option pricing spreadsheet has detected links on this page on the local or global blacklist. 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. A further distinction is that option holders here, i.
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. 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. 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. If it invests next year, the discounted cash flows are 6M with a 66. Yet, if the firm waits for next year, it only invests if discounted cash flows do not decrease. Staged investments are quite often in the pharmaceutical, mineral, and oil industries.
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”. 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. If their stores have low demand, the discounted cash flows per store is 5M.
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 -0. But is it the best alternative? 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 to 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. Where the project’s scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality. Option to expand: Here the project is built with capacity in excess of the expected level of output so that it can produce at higher rate if needed. 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. Option to expand or contract: Here the project is designed such that its operation can be dynamically turned on and off. 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.