Classical DCF Analysis evaluates specific planning scenarios and cannot consider strategic options. In most cases reality differs from planning and management has to make corrections. A real option is the right, but not the obligation to realize business activities, such as deferring, abandoning, expanding, staging or contracting an investment project. Real options analysis (ROA) evaluates these strategic options and expands classic discounted cash flow models. ROA shows what to do in which situation and carries management through uncertainty. Typical real options are:
- Option to expand: If the returns of the project are higher than expected, management takes the opportunity to increase capacity. This is equivalent to a call option in financial markets.
- Option to contract : If the returns of the project are lower than expected, management takes the opportunity to decrease capacity and save operational costs. This is equivalent to a put option in financial markets.
- Option to expand or contract: Depending on the return development, management takes the desired option to increase the benefit. Management may shut down a part or all of the operation when conditions are unfavorable (put option), and may restart operations when conditions improve (a call option). In one of my posts I provide a simple example. A flexible manufacturing system (FMS) is a good example of this type of option. This option is also known as a Switching Option.
- Option to wait / defer: Management has the flexibility to postpone the start of an investment until more information is available. For example, in natural resource exploration a firm can delay mining a deposit until market conditions are favorable. This constitutes an American styled call option.
- Delay option with a product patent: A firm with a patent right on a product has a right to develop and market the product exclusively until the expiration of the patent. The firm will market and develop the product only if the present value of the expected cash flows from the product sales are higher than the development costs. If this does not occur, the firm can shelve the patent not to generate additional costs.
- Option to abandon: Management may have the option to stop a project and to realise a salvage value. If the present value of the remaining cash flows is smaller than the liquidation value, the asset may be sold. This option is also known as a termination option.
- Options to choose allow to choose among several different options types. In one of my posts you can have a look at a simple option to choose.
- Barrier options are taken if they reach a certain barrier.
- Switch options enable to switch between different modes of operation. I provide a simple example in my posts.
- Sequencing options: Projects can be implemented sequentially or in parallel. The sequencing of projects is very important in corporate strategy.
- Compound options include several dependent options in general. The exercise of one option can create further options. Compond options can be parallel and sequential.
- Rainbow / learning options have different sources of uncertainty (market, technology, development, …) and volatilities. This leads to the quadrunomial instead of binomial approach.
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Real options are analyzed using methods of option pricing theory. This includes approximation approaches like binomial models and analytical models such as that of Black-Scholes-Merton (Nobel Prize 1997). Projects usually contain several real options. They have to be analyzed simultaneously, since their option values influence each other and are not additive. A combination of Monte-Carlo-Simulation and approximation methods can lead to highly interesting results in complex problems.
I analyze real options with bi-, tri- or quadrinomial models. In this way I can change all parameters in project’s lifetime as required. I provide a comparison of these approaches with the Black Scholes Merton model in this post. Analytical approaches like Black Scholes Merton are much more restrictive in their premises and cannot represent reality in many cases.
ROA provides a lot of additional information. It evaluates the strategic options (ROV … Real Option Values) and provides additional project key figures such as ENPV (expanded NPV). Additionally ROA shows which option should be executed in which situation. A sensitivity analysis within the ROA evaluates the dependency of the option values on important influencing factors. ROA should be an integral part of any project and financial evaluation. The methods of option price theory can be applied pragmatically and without complex mathematics.