Real Options in Capital Investment: Models, Strategies, and Applications

By Lenos Trigeorgis | Go to book overview

Mason and Merton ( 1985), McDonald and Siegel ( 1985, 1986), Brennan and Schwartz ( 1985a), and Trigeorgis and Mason ( 1987), among others, have promoted option-based valuation to capture the managerial operating flexibility and several strategic considerations embedded in capital investments. This real options literature has been growing, increasingly addressing relatively more complex problems, while currently it is turning more toward applications. These advances in real options have the potential to bring a new, integrative perspective to strategic capital budgeting.

Those employing strategic investment planning should definitely try to take advantage of real option valuation tools. An options-based strategic capital budgeting approach may be able to properly quantify not only managerial operating flexibility, but also synergies, intertemporal dependencies (growth options), and many other strategic aspects of project valuation (see Trigeorgis and Kasanen, 1991). Once investment opportunities are properly seen as collections of real options, strategic planning can more readily be viewed as involving the explicit recognition, creation, and management (optimal exercise) of the portfolio of real options associated with a firm's collection of current and future investment opportunities.

An options approach is thus better able to deal with capital investment as an ongoing process requiring active managerial involvement. As market conditions change, new investment opportunities may be created while old plans may have to be revised or even abandoned. As part of the strategic capital budgeting process, management should be constantly looking for opportunities to exercise the built-in real options or create new ones. If major changes occur in the marketplace or important options are exercised or created that may alter the remaining alternatives, the initial strategy may naturally need to be adjusted. A set of conditional control targets would also be useful to lower-level managers, contingent on the exercise of such major options. Of course, not only should the corporate strategy be flexible enough to evolve over time, but, naturally, the associated control targets should be readjusted as well.


4.6 CONCLUSIONS

Strategic capital budgeting was seen as the process by which top management makes decisions to commit large amounts of scarce financial resources to achieve strategic objectives. In the traditional financial literature (with the exception of the literature on real options), little attention has been devoted to strategic considerations in the asset planning and allocation process. The conventional formulation of the resource allocation problem has been framed in terms of individual projects within existing organizational units. However, these approaches do not always provide top manage

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Real Options in Capital Investment: Models, Strategies, and Applications
Table of contents

Table of contents

  • Title Page iii
  • Contents v
  • Tables and Figures ix
  • Preface xiii
  • Chapter 1 Real Options: An Overview 1
  • Introduction 1
  • Acknowledgments 28
  • Notes 28
  • Part I Real Options and Alternative Valuation Paradigms 29
  • Chapter 2 Methods for Evaluating Capital Investment Decisions Under Uncertainty 31
  • Introduction 31
  • Conclusion 44
  • Notes 45
  • Chapter 3 Merging Finance Theory and Decision Analysis 47
  • Introduction 47
  • Summary and Conclusion 65
  • Acknowledgments 66
  • Notes 66
  • Chapter 4 The Strategic Capital Budgeting Process: A Review of Theories and Practice 69
  • Introduction 69
  • Conclusions 84
  • Acknowledgments 86
  • Notes 86
  • Part II General Exchange or Switching Options and Options Interdependencies 87
  • Chapter 5 The Value of Flexibility: A General Model of Real Options 89
  • Introduction 89
  • Concluding Remarks 105
  • Acknowledgments 105
  • Notes 106
  • Chapter 6 The Valuation of American Exchange Options with Application to Real Options 109
  • Introduction 109
  • Conclusion 119
  • Acknowledgments 120
  • Notes 120
  • Chapter 7 Operating Flexibilities in Capital Budgeting: Substitutability and Complementarity in Real Options 121
  • Introduction 121
  • Conclusion 130
  • Acknowledgments 131
  • Notes 131
  • Part III Strategy, Infrastructure, and Foreign Investment Options 133
  • Chapter 8 The Value of Options in Strategic Acquisitions 135
  • Introduction 135
  • Implications and Conclusions 147
  • Acknowledgments 148
  • Notes 148
  • Chapter 9 Corporate Governance, Long-term Investment Orientation, and Real Options in Japan 151
  • Introduction 151
  • Implications and Conclusions 158
  • Notes 160
  • Chapter 10 Volatile Exchange Rates and the Multinational Firm: Entry, Exit, and Capacity Options 163
  • Introduction 163
  • Conclusions 178
  • Acknowledgments 180
  • Notes 180
  • Part IV Mean Reversion/ Alternative Formulations in Natural Resources, Shipping, and Start - Up Ventures 183
  • Chapter 11 The Effects of Reversion on Commodity Projects of Different Length 185
  • Introduction 185
  • Conclusions and Extensions 199
  • Appendix 201
  • Acknowledgments 204
  • Notes 204
  • Chapter 12 Contingent Claims Evaluation of Mean-Reverting Cash Flows in Shipping 207
  • Introduction 207
  • Conclusions 216
  • Appendix 217
  • Acknowledgments 218
  • Notes 218
  • Chapter 13 Valuing Start-Up Venture Growth Options 221
  • Introduction 221
  • Conclusion 236
  • Appendix 237
  • Acknowledgments 238
  • Notes 238
  • Part V Other Applications: Pollution Compliance, Land Development, Flexible Manufacturing, and Financial Default 241
  • Chapter 14 Investment in Pollution Compliance Options: The Case of Georgia Power 243
  • Introduction 243
  • Notes 262
  • Chapter 15 Optimal Land Development 265
  • Introduction 265
  • Conclusions and Extensions 277
  • Appendix 278
  • Acknowledgments 279
  • Notes 279
  • Chapter 16 Multiproduct Manufacturing with Stochastic Input Prices and Output Yield Uncertainty 281
  • Introduction 281
  • Conclusion 298
  • Appendix 300
  • Notes 301
  • Chapter 17 Default Risk in the Contingent Claims Model of Debt 303
  • Introduction 303
  • Conclusions and Extensions 317
  • Acknowledgments 318
  • Notes 319
  • Bibliography 323
  • Author Index 347
  • Subject Index 351
  • About the Editor and Contributors 357
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