Use of Real Options Theory in Financial Management/Modeling - Term Paper Example

?Introduction This paper is a reflective account of my participation of the finance of my program. It focuses on the use of real options theory in financial management and modeling. It identifies the reasons why this theory is relevant to management in today's world and goes on to describe the new things I learnt in this course. It goes further to identify the activities that facilitated my understanding of the real options theory and other practical application matters connected to the real option theory. The Need for the Real Options Theory The Real Options Theory is a finance theory that is increasingly being used by top-level management and people charged with the governance of businesses to take good financial decisions. In every business, the need to estimate the future cashflow is very important. Businesses have to evaluate the cost of capital and also estimate the future returns that will accrue to the capital when it is invested. In so doing, there is the need for certain forecasting activities to be undertaken to ascertain the future worth of projects and the returns they would yield. From my previous knowledge in finance and economics, I thought the best methods of forecasting and analyzing the cost of capital were the traditional methods like Net Present Value, Internal Rate of Return amongst others. However, at the earliest stages of studying the Real Options Theory, I realized that those systems are too technical in nature. In other words, they are too specialized and do not take cognizance of important elements of businesses. In my observation of the business environment, I notice that ten years ago, most businesses had finance departments that were often very distinct from the rest of the business. The finance departments specialized in the use of techniques like NPV and the like to forecast and submit reports to the people charged with the management of the business. These reports were often very technical and it contained recommendations for those in charge of the companies to take a given course of action. On further reading, I discovered that aside the fact that these techniques were too restrictive, it had some other disadvantages. Copeland & Antikarov (2000) identify that the old techniques of financial forecasting and capital analysis suffered from the tendency of undervaluing a given project. It is common knowledge for people to discount projects and get very good results that indicate that the project is viable. However, in reality, when the project starts, the contractors come back and request for more money. This particular trend is so common that most projects are defined by that kind of trend. This suggests to me that the traditional discounting and forecasting tools and techniques of finance do not take into consideration, important elements of the business environment before they are invoked. In other words, most techniques of finance are limited in scope and due to this, they do not cover strategic issues appreciably and end up being weak tools and techniques for planning in businesses. Also, it is worthy to note that most financial professionals use these tools and techniques based on very specialized technical details. These jargons and assumptions are likely to make a manager with little exposure to finance bored and this can defeat the purpose for which such tools and techniques are used - that is the need to use the reports of such projects for decision making that would bring positive results to the business as a whole. Due to these weaknesses in forecasting tools and techniques, there is the need for some kind of finance technique that will enable managers and top-level decision making groups to take the best decision that brings the optimum results to the organization as a whole. The Real Options Theory I learnt from the course that the Real Options Theory uses decision analysis and other techniques of the valuation option put forward by Black & Scholes to analyze the entire environments before a group of managers can take a decision on a given financial situation. The Real Options Theory enables the idea of financial economics to be linked to strategic decision making. Real Options Theory incorporates uncertainty into the management decision making process. It enables organizational governance issues to be factored into financial related decisions. The Real Options Theory literally bridges the gap between corporate strategy and finance. In an attempt to describe the method, I discovered that the Real Options Theory uses the concept of options as it is utilized in finance to enable top-level management to take decisions in businesses. In finance, an option is the right to make an investment decision without the obligations to do any other thing. I learnt that it is the theory of options in finance that has been extended to create the real options theory. Essentially, the real options theory captures the value of management flexibility to make a decision on a given matter in line with environmental conditions. The real options theory applies the theory of options in finance which seems to quantify the financial and non-financial elements of decision making in an environment of uncertainty. In finance, the concept of options is often used for forward contracts which entails the right to sell a specific asset (put) at a specific price on a specific date or the right to buy (call) a specific asset on specific date (Trigeorgis, 2003). This concept allows a business to identify a series of hedging arrangements which it is free to accept or reject at a given point in time. In making the decision, a business can compare the worth of other options on the market before making a choice. I therefore understood the real options theory as an analysis of the strategic value of investment by taking into account certain important elements of the environment the business operates in before making a financial decision. Therefore, it came to my knowledge through this course that the main advantage that the Real Options theory enjoys over other methods of forecasting and analysis is that it puts a set of financial decisions on given matter into a number of options. Each option is made up of a series of financial projects and actions that sums up to define a given action or a given strategic pathway that is fairly distinct. Each strategic option gives rise to a series of events and possibilities which are valued using financial models and techniques to justify each pathway. Real options therefore gives a business a series of strategic choices based on a given set of financial decisions and choices which the management of the business can take. The Real options theory actually renders values to these strategic choices and attempts to forecast their costs, worth and the interactions of these choices. The analysis of a series of strategies in each set of choices is done with certain strategic implications in mind. Some of these implications include the competitiveness of the business in the long run, the ability to remain profitable not only in the short run but in the long run and also the examination of internal strengths, weaknesses, opportunities and threats. All these come together to make the financial decisions of a given business effective and more importantly applicable to the business in question. How I Studied the Real Options Theory In my studies, I made use of the lectures to grasp the fundamental essence of the theory. I also had a series of discussions with my colleagues to get better explanations of the theory of financial options and how it works in real life. Also, I read numerous prescribed sources to facilitate my understanding of the theory. Personally, I was interested in how the theory works in real life, rather than the theoretical elements of the subject. This is because my aim in this program has always focused on practical efficiency rather than academic proficiency. I also went all out to read additional sources. Since the real options is a relatively new area of finance and it attempts to merge to elements of the study of business ie finance/accounting and strategic management, I had to fall on very modern sources of studies like online resources and other journals that I found in electronic libraries to get an understanding and appreciation of the topic. The Application of the Real Options Theory I discovered in my study of this particular topic that the Real Options Theory has a financial as well as practical/strategic component in application. In the financial aspect of the real options theory uses a capital budgeting approach. The theory is steeped in the fact that options come with two strategic risks. The first is the market priced risk, which involves the risks that elements of the business environment could change adversely against a business. It is therefore important to examine an option in relation to the market priced risks.. Secondly, there is the private risk. This risk implies that a non-public company could go bankrupt and fold up. The Real Options Theory therefore helps businesses to take strategic financial decisions based on empirical facts relevant to the market priced risk and the private risk. This does not only help in the long term survival of the business but also, the profitability of the business. Typically, the theory uses the Black & Scholes approach to examine things and take decisions the financial facts of a several options before taking a decision. The Black and Scholes approach states that for the best results, a business might need to hold two or more assets. One of the assets could be risk free whilst the second asset would be based on the first asset like a shares or some asset of that nature. A third asset, which is a derivative based on the underlying ie the first asset can be introduced. Thus, if important information about the value of each of the options can be ascertained and calculated accurately, management can take a decision on whether to call or put an option. It is therefore important for a business to gain relevant information about a given option and this information needs to be accurate and the markets must be relatively stable. Since this is not possible to attain perfectly in today's environment, a business must constantly monitor the markets to ascertain the value of relevant market factors and make adjustments as required. From my reading of Luehrman's book, I discovered that the important factors come to play in taking real options decisions. It include the need to ascertain the following before taking a decision: 1. The present value of a project's operating asset and this must be reviewed periodically and over long time frame. 2. The actual financial consideration required to pay for the assets of a project and this must be as comprehensive as possible with some flexibility for future adjustments. 3. The time value of money and 4. The market price and public risk involved in a project asset. 5. The duration available for business to evaluate the matter and take a decision. Strategic Management Elements of Real Options In incorporating these technical decision making processes and systems, the non-financial managers need to be included and there is the need to simplify the project in a strategic framework. First of all the business will define a number of investment decision pathways for the top level management of the organization. This involves defining the options and them try to identify the relevant components of each option. Secondly, there is the need to identify the financial worth of each pathway. This will strongly bring out the indicators of the financial viability and feasibility of the project in question. It is therefore important to have the financial values and present values of each component identified in the first stage. Thirdly, there is the need for management to debate over the options and prioritize the various pathways based on a set of quantitative and qualitative standards that they would define. Fourthly, there is the need to evaluate the different paths of the each option and arrive at a strategy. Finally, the management of an organization needs to time and identify the different implementation strategies that are best to put their conclusions into reality and then monitor it. Popular Uses of the Real Options Theory I found in my studies and further research that Amram and Kulatilaka describe the five most common situations in which the real options theory are used in businesses. They are: Wait-to-Invest options, Growth Options, Flexibility Options, Exit Options and Learning Options. The Wait-to-Invest options are used when there is the need for management to take a decision on how to expand their operations. It enables them to identify the various financial implications of two broad groups of options: immediate plant expansion or delayed plant expansion. In other words, they utilize the real options theory to quantify the financial as well as strategic implications of expanding immediately or waiting for market conditions to change before expansion. Thus under each heading the financial valuation of the implications are identified, measured and presented as an aid to decision making. The growth option is primarily involved in the decision of how to enter the market. It utilizes techniques in financial modeling and forecasting to scan the environment and create a series of scenarios that will occur when particular decision paths are taken. This comes with the value of the consideration that would be exchanged over a long period of time when certain market entry strategies are employed. The flexibility options is concerned with the mobility of the operations. It primarily seeks to identify whether to operate a central facility or decentralize, ie create different facilities in different locations. This real options technique is concerned with the siting of operations and how to manage them effectively. So like all other real options techniques, the flexibility options identifies and quantifies the relevant financial and strategic matters in the location of a business and how how it can aid the survival and growth of the business. Exit options involve the identification of options and their values in the event of the development of a new product or in an uncertain market. In this situation, the business examines whether to continue trading or to fold up in a given market or sector. Learning options are related to scenarios and their financial implications on the market in relation to investments. This entails an analysis of the markets at given time intervals and the quantification of all strategically important items prior to making a choice based on the real options theory. Future Implications The main future requirement or implication of the Real Option Theory is that it is a relatively new area of business practice. It is still open to so many studies. Although it attempts to evaluate strategies, it is yet to be understood by many non-financial managers. Conclusion The traditional methods of forecasting and financial analysis are quite isolated from the overall activities of businesses. However, now that strategic management is vital for the survival and growth of businesses, I notice that there is an urgent need to merge financial management with strategic management. The best way of doing this is through the real option theory, which attempts to quantify the worth of strategic options that a business can take in finance terms. I learnt that the Real Options Theory is based on the assessment of market price risk and private risk and this is done through the examination of each option for an asset against these risks. The Black & Scholes model is a popular method of practicing the Real Options theory. Although the real options theory is a good theory, it is still an emerging aspect of finance and it needs to be studied further before it can be used effectively in businesses. References Amram, M. & Kulatilakoa N. (1999) Real Options Harvard Business School Copeland, Tom & Antikarov Vladimir (1999) Real Options New York: Texere Publishing Luehrman, T. A. (1998) “Investment Opportunities in Real Options: Getting Started on the Options” Harvart Business Review July – August, 1998 57-67 Mun, Jonathan (2003) “Using Real Options Software to Value Complex Options” Financial Engineering News Reuer, Jeffrey J, Tong, Tony W. (2007) “Real Options in Strategic Management” in Advances in Strategic Management Vol 24 2007 Elsevier Publishing Schwarz Eduardo (1997) Real Options & Investment under Uncertainty New York: McGraw Hill Trigeorgis, Lenos (1996) Real Options: Managerial Flexibility & Strategy in Resource Allocation MIT Press Read More