Real Options Theory in Financial

¶ … 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).

Real option valuation

Although real options can be valued in different ways, the binomial option-pricing method is one of the most widely used of those methods. In traditional options analysis, the "binomial model breaks down the time to expiration into potentially a very large number of time intervals, or steps" (Hoadley, 2009). While there is no set date of expiration for most real assets, using the binomial model approach in real option analysis one uses the same type of decision tree to determine all of the possible paths that the real asset could take and determine the terminal value of the asset depending on the path. One then works backwards to determine the value of the asset at each different step of the process. In order to understand the binomial option-pricing approach, it is critical to remember that each point on the tree only represents the option of making an investment. The options will not be exercised unless they have a positive value.

One widely-used version of the binomial model is the Black and Scholes approach, which has traditionally been used to value stock options. This approach has also been successfully applied in valuing real options in long-term projects characterized by technical uncertainty. Consideration of these projects usually requires "the consideration of technical and financial risks to quantify the true economic cost associated with the project" (Espinoza & Luccioni, 2007). In fact:

Because projects take time to complete, the cost to complete the project usually includes two different kinds of uncertainties: technical and market uncertainty. For instance, in the case of a contaminated site, technical uncertainty would be: How much contamination is present and, therefore, how much it is going to cost to remediate the site? Technical uncertainty can only be resolved by undertaking the remediation project; actual cost unfolds as the project proceeds. The second kind of uncertainty, referred to as input cost uncertainty, is external to the project. It arises because input prices for labor and materials fluctuate over time (Espinoza & Luccioni, 2007).

To determine the costs of options at different points in time, one can resort to complicated partial differential equations, or simply resort to a modified binomial model, which can approximate the same results as more complex models (Espinoza & Luccioni, 2007).

One can take a linear or a non-linear approach to real-options valuation. One such model is the threshold model. Threshold models have the ability to investigate pricing relationships in different areas. "The law of one price commands equal prices across spatial markets, but transaction costs and other market frictions allow for temporary departure from equilibrium" (Koekebakker, & Sodal, 2007). This is especially relevant in an American market, where transaction costs can be expected to be at least twice as high as transaction costs in other areas of the world. Moreover, threshold models "suggest much faster adjustments in response to deviation to equilibrium than in is the case when thresholds are ignored" (Koekebakker, & Sodal, 2007). Threshold models are useful in more complex situations, where modified binomial models may be too simplistic to accurately predict performance.

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: