Capturing Value with Real Options: Improving the Quality of Managerial Decision Making and Firm Performance by Formally Building the Value of Real Options into Investment Evaluation

Article excerpt

Managerial decisions--which are generally made within the context of uncertainty about future developments and instability in the business environment--have a high rate of failure. It is, therefore, a natural response for managers to be wary of data provided to support decisions, to delay commitment until returns are certain and to maximise flexibility for future actions.

From a financial perspective, these behaviours emerge, respectively, as: a high discount rate relative to the apparent risk of a project or investment; preference for immediate benefit or gratification; and value attributed to any optionality associated with a decision.

In short, managers who cannot secure an immediate payout will prefer courses of action with attached options. This is an intuitive response that is all too infrequently valued and measured. Thus we believe that a Real Options framework can add rigour and structure to decisions by investors and managers.

Real options versus financial options

An option is a contract that can be enforced at the holder's discretion. The contract will have key terms such as details of the asset or security, its price and a termination date.

A call option provides its owner with the right, but not the obligation, to buy an asset at a predetermined exercise price at, or often before, a predetermined exercise date; and a put option gives the right to sell an asset. The most common form of financial option is where the holder has the right to buy (or sell) a share at a certain price. For example, on 22 July 2005, Westpac shares were trading at $19.58 and investors could purchase the right to buy a Westpac share for $19.50 at or before the 28th July for $0.20.

The option holder could exercise their right immediately and (leaving aside transaction costs) receive $0.08; this is the option's intrinsic value. The remaining $0.12 is the option's time value, and represents the value associated with the option holder being able to refrain from exercising the option until the uncertainty associated with the option's ultimate payoff is resolved. The uncertainty that drives time value is itself a function of both the variability in the asset's price and the time until the option expires.

This approach can also be applied to investment decisions by a firm as an extension of typical project evaluation, such as net present value (NPV). This treats projects effectively as a now-or-never proposition and ignores the value in having some degree of flexibility in how management conducts operations in response to new information. Examples of real options include: an option to expand operations; an option to abandon a project and sell the assets in place; the option to alter what is produced or how it is produced; and an option to wait before committing to a new investment decision.

To illustrate, assume, for example, Westpac purchased a piece of land in a rural city and is trying to decide between building a large or a small branch. Standard NPV analysis would compare the NPV of both alternatives, assuming that operations were commenced immediately. However, this completely ignores different real options embedded in the decisions. One, for instance, relates to the timing of any investment: Westpac can wait for further information to help decide between the alternatives. In option terms, this has a time value. Another real option is to build a larger branch than needed immediately and so be able to expand operations if demand increases.

Other real options obtained with building the branch could include the option to: vary operations (for example, switch from a bank branch to a lending centre); expand operations by employing more customer service officers; or abandon operations and sell the property if the branch is no longer viable. …