Real Options

What Are Real Options?

Real options are the type of options that offer flexibility when deciding to expand, defer, wait, or completely give up on a project.

Moreover, they are valuable if the future is unpredictable since they offer us the freedom to invest in projects only when it makes sense.

This flexibility allows us to either reduce losses or generate more profit. This "hand-picking" feature offered by this kind of option makes it stand out. However, keep in mind that the flexibility offered here is useless in the case of a deterministic future.

Without randomness, one may plan out everything they will do in the future—including what to do when to do it, and how much money to invest—and then stick to it. Therefore, they are unnecessary in the absence of randomness.

However, the future's not set in real life, and these options are of value. They are most valuable when there is uncertainty; since the management is willing to use the options and provide freedom to modify the project's trajectory positively.

Understanding Real Options

A real option is vital to a business's success since its ability to select the ideal business opportunity significantly impacts its profitability and expansion.

With this option, the management team can investigate and evaluate business ideas, enabling them to choose the best one.

They are built on the idea of financial options. Hence a solid understanding of financial options is required to understand them.

As the name implies, options contracts are the rights to choose whether to buy or sell a predetermined amount of a specific asset at a specified future date for a predetermined sum of money, known as the strike price or the exercise price.

Managers can evaluate the opportunity cost of continuing or terminating a project using real options value analysis (ROV) and then make better decisions.

ROV, also known as real options analysis (ROA), applies option valuation methods to decisions involving capital budgets. 

For instance, ROV can evaluate the possibility of investing in developing a company's factory and the alternative option of selling the factory.

ROA generally expands its application beyond its usage in corporate finance to decision-making under uncertainty. It does this by extending the techniques developed for financial options to "real-life" decisions.

Types of Real Options

They allow businesses to alter their cash flows and risk profile to improve the project's acceptability and profitability.

Additionally, the availability of these options provides companies with more prospects or possibilities to complete the project successfully, or these options help avoid resource wastage (if the project fails). 

These alternatives may also make the project preferable and more productive than anticipated.

The ability of a company to abandon a project before it is finished is a straightforward example of natural options. Suppose it is firmly believed that the project's earnings will fall short of expectations. This would aid the company in reducing future losses and overall losses as well.

They can be divided into three main categories that can each be further subdivided. The most popular types include

Options for the project size

Flexibility in terms of the size of the required infrastructure is advantageous where the project scope is susceptible to changes.

1. Option of expanding 

It offers the chance to boost corporate activity in the coming future through one project or investment. In this case, the project is built with enough capacity above the expected output level to generate at a higher rate as needed. 

Management has the option, but not the obligation, to grow, i.e., exercise the option. 

The option premium may make it initially more expensive to develop a project with growth potential. However, it will be recognized as higher than one without this option.

2. Option of contract 

It is the option to abandon a big project if the situation changes. The project's design allows for future output reductions if conditions alter. This option entails forgoing these upcoming expenses. 

3. Option to enlarge or reduce 

In this case, the project's operation can be dynamically turned on and off. Management may halt all or a portion of a process when conditions are unfavorable and restart it when the situation improves. 

For instance, an oil and gas company may close one of its facilities during a period of low oil prices and reopen it during a period of high oil prices.

Options relating to project life and timing

It is advantageous to be versatile with scheduling the pertinent project when it is uncertain when or how certain businesses or other circumstances will occur (s). 

1. Options for beginning or delaying 

In this scenario, the project leader can decide when to start or postpone the project.

2. Delay option with a product patent

Until the patent expires, a company with a patented product is given complete authority over the product's marketing and development. The company will only market and develop the product if the anticipated cash streams from the product's sales surpass the development cost. 

If not, the company can keep the patent without spending more money. 

3. Option to stop 

The managers of a project may choose to wrap it up profit from its remaining value. In this case, the asset may be managed to sell if the remaining cash flows' present value is less than its liquidation value.

4. Options for sequencing 

This analysis examines whether implementing these projects in comparison or sequentially is more beneficial. It is similar to the initiation option above but requires flexibility in scheduling numerous interconnected projects. 

Here, the company can lessen confusion regarding the overall venture by maintaining a close eye on the outcomes of the first project. 

Once the problem has been resolved, management can continue or pause the progress of the remaining projects. 

The significance of choice to keep the resources could have been lost if the managers had used them all at once. The corporate strategy needs help with project sequencing.

5. The option to prototype 

The development of new energy production and storage systems is ongoing due to environmental restrictions, resource shortages, and climate change. Some plans are merely slight upgrades over the ones currently in use, while others are extreme. 

Due to the relevant financial and technical uncertainties, systems that encourage innovation are risky investments. 

By spending a tiny part of the cost of a total system and learning technical and financial details about the design, prototyping can reduce these risks in exchange. 

In economics, prototyping is a risk-management technique with a price tag that needs to be carefully calculated.

Options relating to project operation

The product produced or the manufacturing process may be subject to management flexibility. Similar to the previous examples, this flexibility raises the project's value, which corresponds to the "premium" paid for the real option.

1. Options for output mix 

The decision to produce different outputs within the same facility is known as a production mix option or product flexibility. 

These options are helpful where there is fluctuating demand or where there is typically a low overall supply of a specific good, and managerial staff would like to change to a different good or service quickly if necessary.

2. Mix options 

Process flexibility is an input combination option that allows management to use distinct inputs to generate the same output as needed. 

For example, in this case, a farmer will appreciate the flexibility to switch between various feed sources, selecting the most cost-effective option available. 

3. Options for operating scales 

Management may adjust the production rates per unit time or the total output run time in response to changing market conditions. These choices are also known as intensity choices.

Real Options Valuation

Given the facts and circumstances, it is evident that real and financial options can be compared. As a result, we anticipate that options-based modeling and analysis will be used in one such situation. 

The more popular valuation techniques may be inappropriate for ROV, but it's essential to know why. 

Comparing ROV to more popular capital budgeting techniques like discounted cash flows and net present value is inaccurate. 

In the basic NPV approach, prospect expected cash flows are represented as present values that use the probability estimate and a discount rate that considers project risk. 

In the case of ROV, only the projected cash flows are considered; the flexibility to alter corporate strategy in response to actual market realizations is not considered. 

The NPV framework implicitly assumes that management will become inactive once the equity investment is made.

Analysts adjust the forecast numbers, cash flows, discount rate, certainty equivalents, cost of capital, or forecast rates by applying (subjective) haircuts or likelihood.

In contrast, ROV assumes that management is engaged and capable of continuously reacting to market changes. Therefore, these options consider all potential outcomes and recommend the best corporate action plan under these unlikely conditions. 

The firm benefits from the unpredictability of the underlying market because management reduces exposure to each adverse outcome and increases vulnerability to each favorable outcome, resulting in lower earnings variance than the commitment/NPV stance. 

The methods for funding tools in the literary works on contingent assets analysis are used to capture the predicated nature of foreseeable profits in this sort of option mode. 

The approach is referred to as risk-neutral valuation and entails altering the probabilistic model to account for risk while devaluing at the risk-free rate.

When using ROV, the analyst must consider the valuation's inputs, the methodology employed, and any potential technical limitations. 

The payment between outflows and inflows for a particular project is conceptually considered when valuing a real option. 

The inputs that make up an option's value are influenced by the contract terms and the external factors of the area in which a project is located. 

The political, ecological, socially constructed, technical, and legal factors that impact a specific industry impact business terms such as ownership specifics, data gathering costs, and patent information.

Option Contracts Vs. Real Options

Options contracts and real options differ slightly. Real options are projects that include tangible assets. Options contracts, however, refer to financial instruments. Therefore, options Contracts are also known as Financial options.

The holder of the option has a choice. For instance, it does not compel the holder to purchase but gives the right to purchase. As a result, chances are one of the financial assets with the highest liquidity. 

These options typically differ from traditional financial options because they are not frequently traded as securities and often do not entail decisions on underlying assets sold as financial instruments.

Another difference is that management, who are the option holders, in this case, can directly affect the project's value, whereas this does not apply to the underlying security of a financial option.

Additionally, management must rely on their perceptions of uncertainty rather than measuring delay in terms of volatility.

The premium is the cost of holding an option position.

The term "long the option" refers to someone who has purchased an options contract, and "written the option" refers to someone who has sold an options contract. The long party pays the option writer the premium when the contract is signed.

There are five essential details we must contain in the option contract conditions. They are the following: 

1. The underlying asset

2. The amount of the asset to be bought or sold

3. The maturity date

4. The strike price

5. Furthermore, whether the option holder may buy or sell the option.

The critical difference between the two types of options is whether they grant the right to buy or sell the underlying asset:

• A call option gives the right to purchase the underlying assets. 

• A put option gives the right to sell the underlying assets.

Researched & Authored by Laiba Kamran Shamsi | Linkedin

Reviewed and Edited by Krupa Jatania I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capitalization Rate
• Free Cash Flow to Equity (FCFE)
• Net Identifiable Assets
• Net Present Value (NPV)
• Relative Valuation Models