Real options theory in financial management modeling

Real Options Theory in the Real World

It has been more than three quarters of a century since economic times were uncertain as they have been over the past several years, and this has had a major impact on the world's economy and the way in which economic and finance decisions are viewed. A hugely varied myriad of prognoses and identified trends have been put forward by economists and financial analysts, some still predicting the impending doom of a double-dip recession while others maintain that recovery is already strong, but has begun to drastically reshape the world of business in any number of ways. Still others see the recession as no more than a normal if substantial and long over-due correction, and the current period of apparent recovery as the simple progression of business as usual in the global market.

With so many competing theories that come to such drastically different conclusions, finding a way to manage uncertainty is essential for organizations and investors at all levels, and especially for the financing needs of these corporations. Standard valuation models do not really account for uncertainty or the implementation of strategy itself, which can drastically change the long- and even the short-term value of holdings, making these models and current valuations woefully inadequate when it comes to determining financing and investment decisions during the current period, and indeed in any environment of uncertainty. It is for this reason that other models and frameworks for analyzing the current values of holdings and predicted values of finance decisions have been developed.

The Real Options Theory is a model or theoretical framework that utilizes the concepts of financial options and applies them to managerial and finance decision-making scenarios. The ability to make a decision is thus given specific value based on the scenario and the potential decisions that could be made, and this adds strategy and uncertainties into the overall valuation of a company's current position, investments, and capital structure. This theoretical framework has not come into especially wide use despite its ability to model uncertainties and discretionary value and being shown to be fairly accurate in real world circumstances, in part due to criticisms surrounding the basic premise of quantifying uncertainty as this theory does. Examining an application of real options theory, however, make sit very clear that while complex and perhaps somewhat unwieldy, this theory and model can be incredibly useful for many medium and large scale organizations and investment funds/firms.

Primary and Innovative Concepts

Despite the lack of abundant practical application, the past decade has seen a significant growth in scholarly and academic interest into the area and concepts of real options theory (Reuer & Tong 2007; Li & Johnson 2002; Wade 2005). The ability to chart value potentials based on established uncertainties and the ability to manage those uncertainties through decision-making and reallocation of investment resources is a relatively unique feature of this theory, and its potentials are continuing to be explored in a variety of settings (Li & Johnson 2002; Reuer & Tong 2007). The basic premise of the theory is fairly simple, however.

The fundamental concept of real options theory is that managerial decisions regarding finance can be examined and valued just like traditional financial options can (RO.org 2008). Just as financial options consist of the right, through not the obligation, to make a specific purchase or investment with certain specified conditions, finance-focused managerial decisions or "real options" are the right, though not the obligation, to make specific decisions based on various circumstances (RO.org 2008; Wade 2005). This theory could ostensibly be used to model other managerial decisions on a more qualitative basis as well, but it was designed and is almost exclusive used to model financial decisions, primarily those involving capital investment, with decisions affecting and/or influenced by capital structure included to a lesser degree (Reuer & Tong 2007; Li & Johnson 2002). The actual workings of the real options theory and model are more complex than this explanation might seem to suggest, but the essential principle of this theory is its ability to model uncertainty in such a way that decision-making power can be valued, enabling better strategic decisions to be made.

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 effective and secure strategic decisions can be made (Reuer & Tong 2007; Wade 2005).

Real World Application

The fact that the primary focus on the real options theory and model has been academic in nature rather than practical and direct in its application does not mean that real world inferences cannot be drawn from the work that has been conducted and the research that has been published. The degree to which the model created by the real options theory fits real world data and situations is one of the major reasons that this theory has garnered so much interest, and thus even applications and uses of this theoretical framework that remain academic and entirely theoretical can be used to demonstrate the practical usefulness of this theory. Predictions and calculations regarding the real world can be made on an academic basis and still be measured in the real world even without having real and concrete effects, and this is exactly what many academic studies of this theory have accomplished.

In a 2002 study, two researchers demonstrated that using several distinct real options models could provide accurate and successful strategic decisions regarding it investments (Li & Johnson 2002). Essentially, these researchers were able to demonstrate -- first by modeling and then by measuring real world scenarios and organizations -- that the real options theory was accurate in its predictive capabilities so long as enough environmental information was present to derive accurate valuations for various decisions (Li & Johnson 2002). The real options theory always depends on the careful gathering an analysis of comprehensive information, and like all models is only as good as the information fed into it.