Real Options Theory in Financial Research Proposal

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 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).


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.


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