Real options analysis

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In corporate finance, real options analysis applies put option and call option valuation techniques to capital budgeting decisions.^[1]

A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. For example, the opportunity to invest in the expansion of a firm's factory is a real option. In contrast to financial options a real option is not often tradeable—e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision, however, some real options can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future. Some real options are proprietory (owned or exercisable by a single individual or a company) others are shared (can be exercised by many parties). The terminology "real option" is relatively new, whereas business operators have been making capital investment decisions for centuries. However the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such the terminology "real option" is closely tied to these new methods. The term "real option" was coined by Professor Stewart Myers at the MIT Sloan School of Management, this happened most likely around 1977.

Additionally, with real option analysis, uncertainty inherent in investment projects is usually accounted for by risk-adjusting probabilities (a technique known as the equivalent martingale approach). Cash flows can then be discounted at the risk-free rate. With regular DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate (using e.g. the cost of capital) or the cash flows (using certainty equivalents). These methods normally do not properly account for changes in risk over a project's lifecycle and fail to appropriately adapt the risk adjustment. More importantly, the real options approach forces decision makers to be more explicit about the assumptions underlying their projections.

Generally, the most widely used methods are: Closed form solutions, partial differential equations and the binomial lattices. In business strategy, Real Options have been advanced by the construction of option space, where volatility is compared with value-to-cost, NPVq. Latest advances in real option valuation are models that incorporate fuzzy logic and option valuation in fuzzy real option valuation models.

Real options are a field of academic research and at the present one of the leading names in academic real options is Professor Lenos Trigeorgis (U. of Cyprus). An academic conference on real options is organized yearly (Annual International Conference on Real Options).