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REAL OPTIONS PRIMER: A PRACTICAL SYNTHESIS OF CONCEPTS AND VALUATION APPROACHES

REAL OPTIONS PRIMER: A PRACTICAL SYNTHESIS OF CONCEPTS AND VALUATION APPROACHES Strategic capital investment decisions are being made every day in an increasingly uncertain world. While the traditional NPV approach does a reasonable job of valuing simple, passively managed projects, it does not capture the many ways in which a highly uncertain project might evolve, and the ways in which active managers will influence this evolution. In cases where managerial flexibility is a major source of strategic value, companies will want to use real options valuation methods. This article serves as a managerial tutorial on this newer, less understood approach. It uses simple examples to illustrate the essence of four basic categories of real options—timing, growth, production, and abandonment. The examples begin by taking a “binomial” approach to option valuation, in which the value of an investment initiative is allowed to take on two possible future values. Besides being used to illustrate the distinctive features of a real option, the binomial approach also serves to help the reader understand the alternative Black‐Scholes valuation approach (though without requiring the reader to master the complex mathematics underlying Black‐Scholes). Basic instructions for implementing both approaches are provided, along with a discussion of how to set appropriate discount rates and the important role of volatility assessment in the valuation process. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Applied Corporate Finance Wiley

REAL OPTIONS PRIMER: A PRACTICAL SYNTHESIS OF CONCEPTS AND VALUATION APPROACHES

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References (24)

Publisher
Wiley
Copyright
Copyright © 2001 Wiley Subscription Services, Inc., A Wiley Company
ISSN
1078-1196
eISSN
1745-6622
DOI
10.1111/j.1745-6622.2001.tb00328.x
Publisher site
See Article on Publisher Site

Abstract

Strategic capital investment decisions are being made every day in an increasingly uncertain world. While the traditional NPV approach does a reasonable job of valuing simple, passively managed projects, it does not capture the many ways in which a highly uncertain project might evolve, and the ways in which active managers will influence this evolution. In cases where managerial flexibility is a major source of strategic value, companies will want to use real options valuation methods. This article serves as a managerial tutorial on this newer, less understood approach. It uses simple examples to illustrate the essence of four basic categories of real options—timing, growth, production, and abandonment. The examples begin by taking a “binomial” approach to option valuation, in which the value of an investment initiative is allowed to take on two possible future values. Besides being used to illustrate the distinctive features of a real option, the binomial approach also serves to help the reader understand the alternative Black‐Scholes valuation approach (though without requiring the reader to master the complex mathematics underlying Black‐Scholes). Basic instructions for implementing both approaches are provided, along with a discussion of how to set appropriate discount rates and the important role of volatility assessment in the valuation process.

Journal

Journal of Applied Corporate Finance – Wiley

Published: Jun 1, 2001

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