Real options theory pdf

In fact i was discussing this issue with a friend of mine over curry a couple of weeks ago. Pdf on apr 1, 2014, jersone tasso moreira silva and others published real options theory. The implementation of real options theory for economic. Modularity and designforupgradability are two examples of this trend. Applications of option pricing theory to equity valuation, prof. These differences may arise due to the particular real options embedded in the projects and the order in which they can be exercised. Real options theory begins by drawing an analogy between real options and financial options. Real options theory and practice northwestern university. Options video lectures and slides finance theory i. While optionpricing models are indeed a superior valuation tool the purpose to which the theory is generally put we believe real options can provide a. Navy design and acquisition programs has been the emphasis on exible systems and architectures. While investor psychology and perceptions about the future may drive the marketplace, the theory of real options can go a long way towards closing the valuation gap. In the 1970s and the 1980s, developments in the valuation of capitalinvestment opportunities based on options pricing. The present value pv of future discounted expected cash flows is either 10,000 if the market goes up or 5,000 if the market goes down next year.

Real options analysis tools and techniques for valuing strategic. A brief historical background for optionpricing theory is also given. Real options are a complement to, not a substitute for, discounted cash flow analysis. They started a research using options theory to study the value of an offshore lease and the development investment timing. Real options and investment decision making 7 subsequent information. The real options theory in petroleum industry was first introduced by paddock, siegel and smith 8. The real options approach is the only one that gives prominence to the upside potential for risk, based on the argument that uncertainty can sometimes be a source of additional value, especially to those who are poised to take. Heres an approach that not only makes the math of options easier but also helps you make better decisions about exercising them.

A prospect theory based real option analogy for evaluating flexible systems and architectures in naval ship design by joshua knight chair. The analysis of the possible functions of real options to improve the valuation of companies also provided insight on the. Like a financial option, a real option is the right but not the obligation to take. What is real about real options nfinancial options can be valued using arbitrage arguments replicate payoffs using dynamic portfolio of traded underlying assets and riskfree bond since portfolio payoffs are equivalent to option payoffs in each state of nature, price is the same as well nreal options have two unique. This account traces the field generally from its origins to present day. Under the umbrella of the theory of the firm, transaction cost economics tce. Real options are not just about getting a number, they also provide a useful framework for strategic decision making. Real options in theory and practice graeme guthrie financial management association survey and synthesis. The legislator, the judge and the regulator are considered as producers of law who. A real option is the right, but not the obligation, to acquire, expand, contract, abandon or switch some or all of an economic asset on fixed terms on or before the time the opportunity ceases to be available. Real options theory refers to the right, but not the obligation, to take different courses of action for example defer, abandon and expand with respect to real assets for example an oil well, a new product or an acquisition as opposed to an option on financial securities or commodities cima, 2005.

However, the theory of the firm traditionally argues into a similar direction by viewing the firm as either a set of institutions, as set of property rights or as a set of contracts. Obsolescence impede law to capture the objective of an underlying policy. A financial option is a derivative security whose value is derived from the worth and characteristics. Ford developed from financial options theory and pricing models, real options have evolved to become a mainstream area of academic inquiry. Can value important real options, such as value of.

Birge northwestern university informs practice meeting, montreal, may 2002 outline planning questions problems with traditional analyses. Option pricing theory has made vast strides since 1972, when black and. The interpretation of the real option procedure as an organizational process gives way to linking the results of strategic management to those of financial. It provides a solid basis for conceiving, assessing, and evaluating real option investments, which will make it useful to practitioners and students alike. Real options and the theory of the firm abstract from the real options perspective the firm is conceived as a portfolio of real options. Real options analysis applies to sequential decision making under uncertainty. Can value important real options, such as value of land, o. The paddock, model for upstream petroleum applications. It does an excellent job of demystifying a difficult and complex subject. Real options theory in strategic management trigeorgis. The essence of real options to understand the basis of the real options argument and the reasons for its allure, it is easiest to go back to risk assessment tool that we unveiled in chapter 6 decision trees.

Myers 1977 1 first proposed the real options concept, and pointed out the similarities between the financial options and real options. While optionpricing models are indeed a superior valuation tool the purpose to which the theory is generally put we believe real options can provide a systematic framework that will also serve as a strategic tool, and that it is in this strategic application that the real power of real options lies. Real options valuation, also often termed real options analysis, rov or roa applies option. Real options theory assumes that firms also have some choice in when to invest. An alternative methodology applicable to investment analyses in. Real options valuation, also often termed real options analysis, rov or roa applies option valuation techniques to capital budgeting decisions. In essence, the value of real options stems from the fact that when investing in. Reuer2 1 department of accounting and finance, school of management and business. A financial option is a derivative security whose value is derived from the worth and characteristics of another financial security, or the socalled underlying asset. The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty. Real options in theory and practice graeme guthrie oxford. Assumptions and differences from financial options. It is the right but not the obligation to acquire the gross present value of expected cash flows by making an irreversible investment on or before the date the opportunity ceases to be available. If used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project.

From the real options perspective the firm is conceived as a portfolio of real options. Acquisition strategy and ro annual international real. What practitioners needand what this book deliversis a structured approach to systematically applying real options analysis to the wide variety of problems they will meet in business and economics. Financial theory of real options derives its heuristics of investing in exploratory search by inferring future value of todays investments from market prices. A real option itself, is the rightbut not the obligationto undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. Pindyck massachusetts institute of technology cambridge, ma 02142 robert pindyck mit lectures on real options part i august, 2008 1 44. This video lecture covers interpreting payoff diagrams of call and put options and how to use the diagrams in option strategizing and betting on volatility. Real option analysis example 3 a company is considering investing in a project. The discounted cash flow method does not always completely capture the uncertainty of. In rapidly changing areas of law, the writing of rules is a challenging issue for lawmakers. Acquisition strategy and real options mikael collan jani kinnunen institute for advanced management systems research joukahaisenkatu 35 a 4th floor 20520 turku, finland abstract in this paper we will present strategic level real options that acquiring companies have in the corporate acquisitions process.

Real options would fit very naturally most of necessary technical background already covered stochastic calculus, option pricing theory, binomial methods, monte carlo simulation etc scope to remove some of more technical material recommendation. Pdf real options theory for law maker bruno deffains. Morton glantz, renowned educator in finance, author of several books, financial advisor to government usa the book is far and away the clearest, most comprehensive guide to real options analysis to date, and is destined to. Real options theory is a major new framework in the theory of investment decisionmaking. Real options theory and practice outline northwestern university. Expected dividends on the asset, which reduce the price appreciation of the asset, reduce the value of calls and increasing the value of puts. The last quarter century has witnessed substantial growth in applications of real options theory rot to international business ib research. Real options, agency conflicts, and financial policy pdf. A prospect theorybased real option analogy for evaluating. Real options analysisis the clearest book on real options that we have read to date. A real option is a choice made available with business investment opportunities, referred to as real because it typically references a tangible asset instead of financial. More importantly, it is a quantitative method, and is responsive to changing sets of assumptions. Option pricing theory has made vast strides since 1972, when black and scholes published their pathbreaking paper providing a model for valuing dividend.

Real options that arise in the real world often vary radically from one problem to another. Real options in theory and practice focuses on building up a general approach to solving real options problems from the ground up. Monte carlo simulation andreal optionssoftware alone is worth the book price many times over. Assets that are not fully used may still have option value includes contracts, licenses value may be lost when the option is exercised e. Real option theory is concerned with valuing this flexibility, and determining the optimal timing of such investment decisions. Real options and the theory of the firm annual international real. To pick the best growth projects, managers need to use the two methods in tandem. With uncertainty and irreversibility, npv rule is often wrong very wrong. Real options theory in international business springerlink.