Article

Introduction

The Real Options approach to investment under uncertainty can capture the flexibility of managers to adapt and revise later decisions in response to unexpected market developments and reactions from competitors. This managerial operating flexibility can be regarded as being similar to a financial option. An option on an asset confers the right, but not the obligation, to buy (call option) or sell (put option) the asset at a fixed price (the exercise price) at any time on (European option) or before (American option) a given date (maturity).

 

Real Options and capital budgeting

Capital budgeting projects often involve embedded Real Options (managerial and / or operational flexibilities). For example, a company that decides to build a new factory immediately will forego the opportunity to delay construction to wait for additional information about the market for its products. This is the option to postpone and it is equivalent to an American call option on the present value of the profits from operating the factory (the asset) with a strike price equals to the cost of building the factory. With a financial option, market volatility or uncertainty as to the future price of its underlying asset (normally a share) will increase the value of the option itself. The same is true for Real Options, which are options on real assets. In the case of the factory investment, the more uncertain the level of profits, the more valuable will be the option to postpone construction and wait for additional information which will reduce this uncertainty. An investment project that can be postponed is more valuable that an otherwise identical project that can not. This extra value is the value of the flexibility.

Kulatilaka  and Trigeorgis [1,2]  proposed the general real option pricing model based on the idea of switching among different operating modes and implemented using some discrete-time approximation (either binomial lattices or, in general, Markov chains) of the continuous-time dynamics of the state variable. In their approach, given an investment with many embedded options, at any time a decision is to be made, there is an option to switch from the current mode to a different one.  The switching cost of the decision is the strike price of the option. See [3] for a general review of these models. Fairmat, in conjuction with the binomial lattice and network-switching plug-ins, makes easy to model capital budgeting problems as real options problems.

References

[1] N Kulatilaka. Valuing the  exibility of exible manufacturing systems. IEEE Transactions in Engineering Management, 35:250{257, 1998.
[2] N. Kulatilaka and Trigeorgis L. The general  exibility to switch: Real options revisited. International Journal of Finance, 6:778, 1994.
[3] Gamba A. Real options valuation: A monte carlo approach. Available at SSRN: http://ssrn.com/abstract=302613, 2003.