Chapter 2:

Real Options

Chapter Introduction and Objectives:

Managers often overrule NPV based recommendations in capital budgeting on strategic grounds. Does it mean that the NPV approach is flawed? The standard DCF methodology assumes that managers make an investment decision and then see how the market evolves. In many situations managers can wait and then make a decision. The latter is an option - an option to defer or time the investment decision. Pharmaceutical companies, for example, frequently enter into agreements with small biotechnology companies and Universities for research and development. The traditional DCF methodology does not work well in case of such projects because of prolonged development and uncertainty in cash flows. For gaining access to research, the pharmaceutical company makes an up-front payment and a series of progress payments. These contingent payments give the pharmaceutical company the right but not the obligation to make further investments. Such investments are best evaluated as options .

The chapter has the following objectives:

• Highlight different types of financial options
• Bring out an analogy between financial options and real options
• Highlight the different types of real options
• Introduce valuation of real options

Consider a project that has a best outcome of $ 13 m and a worst outcome of $ 9 m. Each of these outcomes are equally likely to occur (probability is 0.5). The expected value of the project, the weighted average of outcomes, is $ 11 m. i.e. (13*0.5 + 9*0.5) = 11

The discounted value at a discount rate of, say, 10 % is 11/1.10 = $ 10 m.

If the initial investment is $ 9.5 m, the NPV is $10m -$9.5m = $ 0.50 m.

Based on NPV, most managers would go ahead with the project. But NPV does not deal with the management's ability to time the project. Suppose the