Real options theory- definition and meaning

August 10, 2021

Real options theory, a modern theory that explains how to make strategic investment decisions when the future is uncertain, is called real options theory. Real options theory draws parallels to the valuation methods of financial options and the real economy. This theory is a favorite theme in many business schools around the globe and the boardroom, particularly within oil companies.

A ‘real option’ in business is a decision that a company has regarding an investment opportunity. It refers to tangible assets and not financial instruments.

Real options approach can include the decision to build or change a factory, upgrade machinery and technology, purchase lucrative oil fields, and decide when to drill or pump. They don’t include derivative financial instruments like stocks and bonds.

Investment options with tangible assets are similar to financial instruments. The same method could be used to value tangible assets (real assets).

The Economist’s glossary contains the following comment about real option theory.

Traditional investment theory states that a firm should calculate the Net Present Value (NPV) before evaluating a project. If it’s positive, then it should proceed.

Real option theory presumes that firms have the option of choosing when and where to invest. The project is, in other words, an option. There is an option but no obligation to proceed with it.

Real options theory – a new theory

Real Options Theory is a new framework for investment decision theory. It modifies the standard theory of investment decision, the Expect Net Present Value theory. The NPV theory predicts the future cash flows for an investment project. If there is uncertainty, the expected value is determined. The estimated future cash flows are then given at discount rate at the cost to the corporation, and the summated results are calculated. If the NPV for the project is positive, it is worth considering. Negative NPV should be rejected. The corporation doesn’t care if the NPV is negative or positive.

Real Options theory fills in the gaps where NPV theory is weak. This is because subsequent decisions could alter the project’s outcome after it has been completed. NPV does not allow for flexibility and therefore undervalues the project’s benefits. It was not unusual for the highest bids to exceed the net present value calculation in the auction of petroleum exploration contracts. Because the winning bidder knew that once initial drilling had been completed, the company could either stop or expand exploration based on that information.

Real Options Analysis can be related to decision tree analysis, related to Richard Bellman’s Dynamic Programming. Real Options Theory is a formal theory for the option values. This theory was developed by Fischer Black, Myron Schles, and Robert C. Merton.

Real options theory – an example

Most companies include investment or financial option with a variety of managerial flexibility.

Imagine, for example, an oil company that believes it has found a new oilfield.

But, no one knows how much oil there is. They also don’t know what the price of oil will be once they start pumping it.

They must make two choices:

-Purchase Start drilling and sign the lease

-If Oil Is Discovered Should they start pumping?

Oil prices are subject to significant fluctuations, which we all know. It would be more sensible to wait until oil prices are significantly higher than the NPV equation of zero before granting permission.

The Economist’s glossary explains how the choices made by the oil company are similar to those of an investor looking at financial instruments.

“In the example of an oil company, the cost for LAND corresponds with the down-payment on the call (right to purchase) option and the additional initial investment required to start production at its strike price (the amount that has to be paid if it is exercised).

“As with financial option, it is worth more to keep the option in existence longer than the expiration date. Also, the less volatile the current price of the underlying asset (in our case oil), the greater the option’s value.”

This is the logic behind real options analysis. However, pricing financial option and valuing real alternatives is challenging in practice.

Types of Real Option

The company has the option of delaying investing. If new information is available when it should be made, they can make a better decision.

Option for abandonment; the company can decide to stop working on a project if it is more profitable to exit than to continue with it. This option is similar to a call option.

These options are fundamental. They are not available in all cases. A mine is an example. Whether the company is mining raw materials or not, it all depends on the company’s flexibility.

Expansion options. These options are similar to the call option. If the project is successful, the company may make additional investments.

Flexibility options are related to the operational aspects; there are two kinds of flexibility options, price-setting options, and production-flexibility options. The company can alter the price. The second scenario allows the company to change the amount of its production.

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