Real options theory in financial management and modeling

¶ … Real Options Theory in Financial Management and Modeling

Real options theory uses traditional financial options theory and applies to them to real investments. This combination adds flexibility to management decisions, allowing management to capitalize on future uncertainties. Theoretically, real options theory can bring the traditional discipline of the financial markets to company opportunities. This is important, because financial markets have traditionally had an advantage over real investments, in that they provide greater opportunities to exit financial strategies that are not working. Though it has been in use for approximately a decade, the real-options approach is considered state-of-the-art because it "allows management to characterize and communicate the strategic value of an investment project" (Real options in theory and practice, 2008). It also improves upon traditional methods, such as net present value, which "fail to accurately capture the economic value of investments in an environment of widespread uncertainty and rapid change" (Real options in theory and practice, 2008). If any economic time in recent history could be described as rapidly changing or uncertain, the present economic climate certainly qualifies, which means that if real options theory can live up to its hype, it may be the best approach for managers to take to weather the current economic crises.

Definition

Because real options analysis extends financial option theory to the financial consideration of real assets, one must understand financial option theory in order to understand how it could be applied to real assets. "A financial option gives its owner the right- but not the obligation- to purchase or sell a security at a given price. Analogously, a company that has a real option has the right- but not the obligation- to make a potentially value-accretive investment. Investment examples include new plants, line extensions, joint ventures, and licensing agreements" (Mauboussin, 1999). Real option analysis does not replace more traditional methods of investment opportunity valuation, like discounted cash flow (DCF) analysis, but, instead, compliments them.

Discounted cash flow analysis

Traditional DCF "analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one" (Discounted cash flow- DCF, 2009). While DCF can be a very helpful tool, it has a rigidity that hampers its utility in a changing and uncertain business market. Therefore, DCF is inferior to real options analysis in at least three ways. First, DCF lacks the flexibility that real options analysis has. This is because the net present value (NPV) rule fails to "factor in the value of uncertainty." (Mauboussin, 1999). DCF also lacks the ability to look at future investments on a contingent basis, which can cause them to make financial decisions that seem irresponsible from a present-day perspective, when they may actually be financially sound decisions, designed to open up access to future investment opportunities. Under the NPV rule, these investments would be deemed to have negative value, making it clear that traditional DCF analysis does not adequately consider the value of future economic opportunities. Finally, traditional DCF analysis does not adequately reflect the economic opportunities present in volatile markets. "In standard finance, higher volatility means higher discount rates and lower net present values. In options theory, higher volatility- because of asymmetric payoff schemes- leads to higher option value" (Mauboussin, 1999).

Financial Planning

Real options analysis involves a different approach to financial modeling than traditional business analysis. Real option analysis presents three types of option categories. These categories include: invest/grow, defer/learn, and divest/shrink (Mauboussin, 1999). The invest/grow category represents the optimistic point-of-view and presents three options for a business: scale up, switch up, and scope up (Mauboussin, 1999). The scale-up option means that "well positioned businesses can scale up later through cost-effective sequential investments as market grows" and would be most useful in high technology, multinational, strategic acquisition and R&D intensive businesses (Mauboussin, 1999). The switch-up option is "a flexibility option to switch products, process on plants given a shift in underlying price or demand of inputs or outputs" and is best utilized when the company deals with small-batch goods production, utilities, or farming (Mauboussin, 1999). The scope-up option applies when a business is ready to extend its traditional scope of business and implies that "investments in proprietary assets in one industry enables company to enter another industry cost effectively," and is used with companies that are the de-facto standard bearers in an industry or companies with a lock-in (Mauboussin, 1999).

The neutral approach is represented by the defer/learn category. The study/start option is best used with companies that deal in natural resources or real estate development and is characterized by delaying "investment until more information or skill is acquired" (Mauboussin, 1999). While this approach may be most applicable to a business dealing with natural resources, where more study may be necessary, the study/start approach can be applied successfully in any industry. Basically, the study/start approach is applicable any time that a company wishes to do more research in an area before committing to a financial plan. This is an area of corporate valuation that can be very tricky, because it deals with previously unchartered financial waters:

Corporate valuation is certainly a challenging subject. The challenge is greater when the firm subject to valuation is a start-up since the task must be accomplished without any information about its past performance supporting the necessary forecasts. The difficulties practically pile up when the industry is new as well. That is not all, the subject can get more complicated when the start-up is one of those firms for which innovation is the main driver of value because there is much uncertainty surrounding the success - and survival - of these firms (Maya, 2004).

In order to perform these necessary financial forecasts, regardless of the surrounding industry, the company may need to perform a study-start up analysis. The reason that the subject lends itself to natural resources or real estate is that there will be some information available in those areas, making the valuation less difficult than in innovative areas.

The pessimistic approach is characterized by the divest/shrink option. When a firm is divesting or shrinking it can first scale down, which means that it can "shrink or shut down a project part way through if new information changes the expected payoffs;" this option lends itself to capital intensive industries or industries dealing with financial services (Mauboussin, 1999). Rather than shutting down a project, a company can also choose to switch down, which involves switching "to more cost-effective and flexible assets as new information is obtained," and might be used in smaller companies, where the wholesale shut-down of a project could end a business (Mauboussin, 1999). The scope-down option is the mirror image of the above-mentioned scope-up option, and generally applies to multi-tiered businesses like conglomerates. Under the scope-down option a company limits "the scope of (or abandon[s]) operations in a related industry when there is no further potential in a business industry" (Mauboussin, 1999).

Real option analysis and venture capitalism

Real option analysis may find its greatest application in venture capitalism, because real option analysis allows for the objective determination of value and also provides prospective investors with exit strategies if a venture becomes unsuccessful. However, the one thing that really separates venture capitalism from other areas of business finance is the optimism involved. Therefore, Giat, Hackman, and Subramanian sought to incorporate optimism into the valuation equation, by acknowledging that some decision making is not driven by rational-thought alone. In addition, they acknowledge that, especially in venture capital scenarios, there may be significant asymmetry in the beliefs regarding the potential success of a particular product. The result of that incorporation is a:

dynamic, structural model of venture capital investment [which can] derive quantitative assessments of the impact of entrepreneurial optimism on the characteristics of venture capital relationships the economic value they generate, the structures of dynamic contracts between venture capitalists (VCs) and entrepreneurs (ENs), the durations of VC relationships, the manner in which VC investment is staged over time, and the extent to which EN optimism could mitigate agency costs of risk-sharing between VCs and ENs (2007).

Entrepreneurs seeking venture capitalist investments are not only concerned with the financial bottom-line, a position understood by many working in the real-option field. In well-established corporations with real options embedded, "moral hazard is given by the risk aversion of managers and the size of real options, implying that the greater the value of real options, the greater the moral hazard" (Siller & Otalora, 2007). However, it is important to keep in mind that the measure of moral hazard is very dependent upon the role of the manger, whether the manager recognizes real options before or after entering the firm. In fact:

If [the] manager is risk neutral or if manager effort does not impact the real options value, the moral hazard disappears, even when real options are present in the firm.

When the manager is an entrepreneur that contributes with intangible assets to firm, the moral hazard depends on the value of real options and the percentage he receives of free cash flows. The greater the real options value, the greater the percentage he must receive of dividends, otherwise moral hazard increases (Siller & Otalora, 2007).

What the above makes clear is that a thorough real options analysis, especially in the context of venture capitalism, must consider real assets as well as intangible assets, such as human capital and intellectual property, even that without foreseeable value.

Finally, real options analysis can have an impact on the role that venture capitalists play in corporate governance. Real options analysis hinges upon the idea that management can exit unsuccessful ventures, but it also considers the fact that people can have different points-of-view about the likelihood of success, which would impact the figures used in such an analysis. Kulatilaka, Lin, and Patel investigated whether venture capitalists should retain a post-IPO equity stake in a company (2007). What they discovered is that venture capitalists should only retain such a stake when companies have poor prospects, otherwise they should fully exit from the company. However, they acknowledge that the timing of exits can, in and of themselves, have an impact on the perceived value and likelihood of success for a venture (Kulatilaka, Lin, & Patel, 2007).

Conclusion

Real options analysis adds flexibility to traditional valuation methods, which makes it a good tool to value firms in today's increasingly difficult-to-value industries. For example, it is almost impossible to accurately predict the future valuation of a wholly-new venture, and even ventures with a short-track record of success, such as.coms, can experience violent market fluctuations that make valuation an even more difficult enterprise. Real option analysis allows the analyst to inject some of the market variables into the analysis and to determine the best strategy at different points in time. Because real option analysis does not necessarily involve long-term commitments, they can be very useful when considering whether to fund a start up, expand into new territory, or market a new product. In short, real options can bring the discipline of financial markets to internal company business decisions. However, in an era when the markets have gone haywire and the experts disagree about the economic future of the markets, one must wonder about the future applicability of real option analysis.