Real Options Theory In Financial Research Proposal

Length: 8 pages Sources: 10 Subject: Business Type: Research Proposal Paper: #40789768 Related Topics: Financial Planning, Theory X And Theory Y, Net Present Value, Decision Theory
Excerpt from Research Proposal :

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

...

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.

References

Discounted cash flow- DCF. (2009). Retrieved February 2, 2009, from Investopedia.com.

Web site: http://www.investopedia.com/terms/d/dcf.asp

Espinoza, R.D. And Luccioni, L.X. (2007). Simplified investment valuation model for projects with technical uncertainty and time to build. Retrieved February 1, 2009, from Real-Options.org. Web site: http://www.realoptions.org/Academic/espinoza_new.pdf

Giat, Y., Hackman, S., and Subramanian, a. (2007). Risk, uncertainty and optimism in venture capital relationships. (2007). Retrieved February 3, 2009, from Real-Options.org. Web site: http://www.realoptions.org/Academic/Subramanian_

VentureCapital_RealOptionsConference.pdf

Hoadley, P. (2009). Option pricing models and the "Greeks." Retrieved February 2, 2009, from Hoadley Trading and Investment Tools.

Web site: http://www.hoadley.net/options/bs.htm

Koekebakker, S. And Sodal, S. (2007). Real options models with non-linear dynamics.

Retrieved February 3, 2009, from Real-Options.org. Web site: http://www.realoptions.org/Academic/koekebakker-sodal-rog2007-revised.pdf

Kulatilaka, N., Lin, L., Patel, J. (2007). Post-IPO governance: Venture capitalists' role in strategic decisions. Retrieved February 2, 2009, from Real-Options.org

Web site: http://www.realoptions.org/Academic/VC.pdf

Mauboussin, M. (1999). Get real: using real options in security analysis. Retrieved February

2, 2009, from Value Sweep.com. Web site: http://www.valuesweep.com/getreal.pdf

Maya, C. (2004). In search of the true value of a start-up firm: Creative destruction and options approach (CD-ROA). Retrieved February 3, 2009, from Real-Options.org

Web site: http://www.realoptions.org/papers2004/MayaCreativeDest.pdf

Real options in theory and practice: What are real options? (2008). Retrieved February 1, 2009, from Real-Options.org. Web site: http://www.real-options.org/

Siller, G. And Otalora, G. (2007). Moral hazard when the entrepreneur seeks outside equity.

Retrieved February 2, 2009, from Real-Options.org.

Web site: http://www.realoptions.org/Academic/Siller.pdf

Sources Used in Documents:

References

Discounted cash flow- DCF. (2009). Retrieved February 2, 2009, from Investopedia.com.

Web site: http://www.investopedia.com/terms/d/dcf.asp

Espinoza, R.D. And Luccioni, L.X. (2007). Simplified investment valuation model for projects with technical uncertainty and time to build. Retrieved February 1, 2009, from Real-Options.org. Web site: http://www.realoptions.org/Academic/espinoza_new.pdf

Giat, Y., Hackman, S., and Subramanian, a. (2007). Risk, uncertainty and optimism in venture capital relationships. (2007). Retrieved February 3, 2009, from Real-Options.org. Web site: http://www.realoptions.org/Academic/Subramanian_


Cite this Document:

"Real Options Theory In Financial" (2009, February 03) Retrieved October 21, 2021, from
https://www.paperdue.com/essay/real-options-theory-in-financial-25093

"Real Options Theory In Financial" 03 February 2009. Web.21 October. 2021. <
https://www.paperdue.com/essay/real-options-theory-in-financial-25093>

"Real Options Theory In Financial", 03 February 2009, Accessed.21 October. 2021,
https://www.paperdue.com/essay/real-options-theory-in-financial-25093

Related Documents
Real Options Theory in the
Words: 1336 Length: 5 Pages Topic: Economics Paper #: 65105746

Different theorists and proponents of real options theory identify different specifics of the theories operation, but in one widely held view there are five real options: the waiting-to-invest option, the growth option, the flexibility option, the exit option and the learning option (Wade 2005). Each one of these options takes in a different value given other environmental and internal considerations, and from the plotted valuations of these real options more

Real Options Valuation Market Investors Often Carry
Words: 1336 Length: 4 Pages Topic: Economics Paper #: 59550500

Real Options Valuation Market investors often carry out their research in a sell side or buy side method. Sell side carry out their investment research to enable them satisfy buy side customers. They carry out this research to generate business or reach the goal of generating transactions. The buy side follows the prospective of banking customers as away of attracting new customers and a service to past customers. Sell side firms

Real Options Valuation
Words: 1780 Length: 6 Pages Topic: Economics Paper #: 21289133

Real options valuation: KLM airlines flight options The object of this paper is to deliver a real option valuation of an option on an air ticket from KLM Airlines. The paper consists of several parts: (i) a file explaining the problem, the modeling choices and the solutions (ii) a table with calculations and; (iii) the conclusion. The value of an options contract relies on a variety of different variables. In addition to

Real Options Analysis
Words: 3230 Length: 8 Pages Topic: Economics Paper #: 11242875

Real Options Analysis Companies resort to capital budgeting in the process of taking decisions with regard to making long-term investments. The projects involving capital budgeting are chosen by the companies in terms of expected generation of cash flows. Since profitability is the main criterion for long-term investments of the companies the strategic decisions with regard to the long-term investments involves a cost-benefit analysis in terms of cost of investments and expected

Financial Theories Financial Theory General
Words: 2088 Length: 7 Pages Topic: Business Paper #: 55088693

" Bhattacharya (1988). It is used to calculate the value of a company based on its total cash flow. (Ross, 1988). Bhattacharya (1998) states that this theory assumed that lower dividends will lead to reduced levels of new equity and this will bring about a balance between the debt and equity of a company. This is not ture for utilities companies and other monopolistic firms where new equities are rare. For the

Real Estate in Greece the
Words: 6076 Length: 20 Pages Topic: Urban Studies Paper #: 98298755

(Economou and Trichias, 2009) Remuneration is stated to be as follows for each of these actors: (1) real estate brokers -- Commission based on percentage of the transaction value; (2) lawyers -- Commission based on percentage of the transaction value; (3) Notaries -- Commission base don percentage of the transaction value; (4) Civil Engineers -- According to specific regulations, taking into account elements of the property in question; and (5) Constructors -- percentage of