Managers around the world are facing increasing uncertainty while taking complex strategic decisions, having an enduring impact on organization profitability. Usually, this uncertainty erodes real value when such decisions are evaluated using conventional techniques, such as NPV or IRR - larger discounting rates are applied to riskier projects. Real options technique presents a way to befriend uncertainty and profit from it.
A real option is the right, but not the
obligation, to take an action that will either help maximize the upside
or limit the downside of a capital investment.
Like financial options, real options can be valued using options-pricing
Common Real Options and Sample Scenarios :
(Adapted from Real Options: Managing Strategic Investment in an Uncertain
World, by Martha Amram and Nalin Kulatilaka (Oxford University Press,
Discounted cash flow has its roots in stock and bond valuation, where investors are necessarily passive. Applied to real assets, NPV assumes passive management; the end result is known in advance, and managers are not expected to add significant value to a project.
Real-options valuation, by contrast, recognizes that managers can and do obtain valuable information after a project is launched, and that their informed actions can make a big difference. Thus, real options seeks to uncover and quantify a project's embedded options, or critical decision points. The greater the uncertainty and flexibility, the greater the value of management's options. Indeed, NPV could be viewed as a special case of real options - one applying to projects with little or no uncertainty and flexibility.
An example of an embedded option is value of investing in development of a blockbuster drug. Process and technical knowledge gained during the development process could be used to improve design and efficacy of existing drugs. The company also has the option to launch related drugs, less expensively, based on competence acquired during drug development. The value of these options has to be factored into the original investment decision.
Applications for real options are in the industries characterized by
large capital investments and quite a bit of uncertainty
and flexibility - particularly oil and gas, mining, pharmaceuticals,
and biotechnology. Companies in those industries also have plenty of the
market or research-and-development data needed to make confident assumptions
about uncertainties in real-options analysis.
Information technology is another fertile, cross-industry field for applying real options. IT now consumes the greater part of corporate capital budgets, and large applications are notoriously risky. However, their deployment can be optimized, and the risk minimized, through real-options analysis. Real-option analysis has recently been used to determine the optimal rollout of an enterprise data warehouse, via the phase-wise consolidation of data marts.
The main challenges to using real options are:
Apart from the benefit of more precise valuations, a subtle side benefit of real options lies in the way it forces managers to chart the entire course of a project, to explore all the options that the project creates. The need to build multiple scenarios to arrive at alternate outcomes also helps widen managerial perspective, and helps them guard against potential downside of decisions.