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Concepts in Real Options - An Overview

(based on L. Trigeorgis, Real Options, MIT Press, 1996)

Real options bridge the gap between finance and strategic planning by providing a means to incorporate both the impact of uncertainty inherent in investment opportunities and how managerial actions can limit losses or capitalize on upside potential. This valuation process not only guides managers to focus on the different opportunities and strategic alternatives, but also provides a systematic methodology to measure the influence of contingent actions on the very nature of risk itself and its impact on project value.

Traditional capital budgeting assumes management is passively committed to project implementation thereby treating value as derived from expected cash flows alone. Based on option-pricing theory, real options expand value by improving upside potential while limiting downside losses. The real options framework allows managers to enhance shareholder value in dynamic businesses through the creation and optimal management of strategic and operating options. Typically, the underlying asset is the gross project value of discounted expected operating cash inflows. Sometimes, multiple stochastic variables are needed to define a sufficient state space for decision-making. This value manifests as a collection of real options embedded in capital-investment opportunities.  Managerial flexibility that can adapt future decisions to unexpected market developments represents a critical source of value creation in a changing environment. Many types of real options occur naturally while others may be planned or built in at some extra cost from the outset. Multiple interacting options can occur in parallel, in sequential contingent stages, or a combination of these to yield a combined value different from the sum of separate parts. Competitive interactions can impact strategic investment decisions. Optimal investment timing policies in a preemptive competitive environment may differ under anticipated unilateral or multilateral damage. The impact of random competitive arrivals and simple game-theoretic competitive reactions can be analyzed in an options-valuation framework. When analytic solutions are not available, standard numerical methods based on simulation, finite-difference or lattice methods are used to solve complex option problems with multiple interacting options and multiple underlying uncertainties. An option-based strategic planning and control framework integrates various sources of value such as synergy among groups of parallel projects and interdependencies among projects over time to provide a rationale for control of targets.