Real Options Are Definite Alternatives to an Investment - Essay Example

 Real Options Table of Contents Content Page Real Options ……………………………………………………………3 Financial Management Theories…………………………………………8 Effects and Responses to real options in management………………….9 Summary and Conclusion………………………………………………...10 References ………………………………………………………………..11 Real Options Real options are definite alternatives to an investment. These options relate to tangible assets such as capital investments. They present situations that could lead to venturing into a new opportunity or closure of an existing path in a business lane. Real options can hook the flexibility of managerial set up as well as the strategic value attached to an investment. Point to note, a real option is a possibility venture not an obligatory course. Real options are not traded as financial securities, but their holders, primarily the managers of an investment, can influence the course of the real option. Extensively, real option analysis is applied in decision making under uncertainty and in corporate finance management. Naturally, real options, under a flexible management, relate to project timing, size and how a project will operate upon establishment. How do real options pertaining to the life and timing of a project arise? The expansion of a business takes so many options with disregards to a number of these permissible realities. Do uncertainties arise in the course of establishing the size of an investment? Technically, the evaluation and analysis of these alternatives becomes valuable and necessary in any circumstance. It is a solid way of having a constructive approach to solving the uncertainty brought about by these options. How are real options evaluated? The existence of these harsh realities presents a massive blow to investments; however, analysts can counter that effectively well. Real options are evaluated using techniques borrowed from methods developed for evaluating financial options. Although most real problems follow an American style path and a variety of variables influences them, standard solutions are limited in solving them. A black-scholes or closed form approach is one of these techniques. This technique assumes deterministic costs or constant where both the project’s revenue and cost are assumed stochastic. As a result, Margrabes formula can be employed to value the real option of having more revenue than the cost. Similarly, binomial lattices can solve the prevalence of alternatives. Binomial lattices are applied greatly because most options seem to obey American real option styles. However, these lattices cannot handle a huge problem. Monte Carlo methods also offer solutions to these issues. These methods have capabilities of handling massive problems. They work out solutions by simulating all possible sources of real options destabilizing the value of a business. If the uncertainties can be modeled using partial differential equations then finite difference methods for pricing are employed to offer solutions. However, this approach is not greatly used and cannot be applied to complex scenarios. This is because of the comparative complexity of mathematical representations. Use of standard techniques to evaluate real options Traditionally the use of standard techniques was predominant though lacked merit in its application. The techniques included use discounted cash flows and net present value analysis. Here, future expected cash flows are treated as the present values under the empirical probability measure that reflects the risk of the project under a discounted rate. Cash flows that is expected is highly valued in this approach than any other flexible issue that alters the strategy to market goal realizations. The net present value approach presents management as being passive to their Capital investment. Most analysts account for this real option problem by adjusting the discount rates. However, real option valuation looks at management as being active and they revolve interests with varying market trends. Real options usually bring into action the best contingent plan. Management has a duty to fight any negative occurrences by lowering the possibilities of exposure and limit the firm’s benefits from uncertainties in the market. Using Options based valuation The contingent characteristic of profits to be realized in the future of a business, in real option models is exhibited by applying financial option techniques. Using the risk-neutral measure approach comprises the reduction of the probability distribution for risk being accounted for. Real option valuation accounts for uncertainties in the future of definite parameters that define the value of the business. The management’s strength to evaluate and counter the evolution of these deterministic parameters makes real option valuation technically harder than financial options. Case Study: Real Options Incorporated To an Investment Project Real options capture the mandate of a managerial person to introducing meaningful value to a project through investment in opportunities. Investments related to real assets have several options that must be adhered to either maximize the value or decrease perceived losses. Project evaluation using methods such as discounted cash flows has major disapprovals. These methods assume irreversibility of decisions made and perceive an investment to passive in nature. Under this case study, all types of real options are discussed and their effects to an investment. Similarly, the key methods used to evaluate real options: the black Scholes mode and the binomial model are discussed, and used to illustrate the value of real options in a project investment. Types of Real Options Growth Options These are associated with projects with extreme negative net present value, regardless of that, they allow other projects that have large net present value to precede hence cover up the generated losses. Operating Options These options give investors key indicators to organize their business operations to maximize value in future. Exit options These are valuable options as they enable an investment avoid irresponsive cash flows. Flexibility options This is whereby; different assets are brought together, because an economic situation dictates. Timing options The decision to delay an investment gives rise to new insights regarding uncertainties that could arise hence create added value to an investment. Real Options Evaluation Given that n investment project has an initial of 1000 and generates in 4 years discounted cash-flows of 200,300,400 and 500, computing the value of the real options attached to this investment project with assumptions that the risk-free rate is 5% and the volatility rate is 10%. For the exit option consider selling the investment at 60% of its initial value. Delaying option consider a period of 2 years of delaying the investment project and a dividend rate of 10%. Real Option Values Option Elements Exit option Delay option Option to expand Underlying asset value 1800 1800 300 Exercise price 1200 720 200 Maturity period 2 5 2 Risk-free rate 5% 5% 5% Volatility 10% 10% 10% Dividend rate 10% 10% 10% Option Value 556,50 63,68 72,74 Real options capture the management’s key role in creating value for the project through investment. Therefore, these options have real values and can be assessed using mathematical models such as binomial or black-shoe models. Financial management Theories Theory of Constraints Theory of constraints focuses on the values of an investment with references to the obstacles in decision-making. The performance of a business depends on several constraints. Theory of constraints is a managing paradigm that identifies the most limiting factors that can be obstacles to achieving realistic goals. The theory comes up with suggestions on how to avert this situation. Theory of constraints focuses on reduced inventory, fast improvement, profit increment and improved capacity. The theory asserts that every undertaken process has a constraint and that the successful completion or expansion, exit or delay of such a project is dependent on improving that particular constraint. The focus is to make the constraint a non-limiting factor all areas pertaining to success of the enterprising concept.Toc (theory of constraints) runs through a series of check points in eliminating possible obstacles or constraints:. Identify Identifies the main constraint in the chain of operations and gives suggestion of limiting its existence. Exploit Conditions that favor the constraints be evaluated and corrected using available materials. Subordinate Reviewing the process steps so that all tasks run concurrently and none of them behaves in a way that constrains the other. Elevate and repeat If the constraints recur, involves continued actions to eliminate a constraint. The steps are repeated to eliminate the constraints permanently. Effects and Responses to real options in management It is evident that real options prove to be a nuisance in management, it is therefore vital to highlight its effects and possible solutions to a number of its manifestations. How do real options pertaining to the life and timing of a project arise? They arise when there is uncertainty with regard to the start and establishment of the project. There are growth real options which define the most appropriate and profitable project to be prioritized. Option to abandon exists when the present cash flows fall below the liquidation levels. Similarly, the option of sequencing comes into effect during determining the priority of similar projects in an investment. Options-based approaches must be employed to avert these occurrences and possible realities. A Related Article on a Current Wall Street Journal In the latest wall street journal, the author focuses on how real options are implemented in corporate issues and their impact in that set up. The article looks at real options in three different domains: as an organization wide-tool, as a way of thinking and as an analytical evaluation tool. In some companies, as the journal points out, real options are employed to drive the firm’s success by managing potential flexibility sources. This is real option application as an organization wide-tool. Also in some firms, real options are used as an input into the M&A process, with little numerical analysis being applied.Here, real options act as a way of thinking. As an analytical tool, real options are joined with commodity trading patterns with well-specified contracts and a must consideration. Companies that have indicated great interests in real options majorly dealt in investments that had large unexplained uncertainties such as life sciences and petroleum products. The article highlights the path worth taking for successfully applying real options in an investment, which included conducting pilot projects, coordinating real options through expert operating teams, acquiring buy-in from senior and mid-level as well as rank-and-file managers and getting specialist training, and customization. Summary and Conclusion As Christopher Cotropia (2009), summarizes excitingly the patents of real options. Real options create the right but not an obligation to undertake a purchase or investment. They also help in determining the best decisions to take in all possibilities of a project. It is necessary to have comprehensive responses to all the queries in this chapter because they constitute real life ventures in all social and economic investments. Reference Eugene B., & ‎Phillip, D. (2015). Intermediate Financial Management 12E. Boston, University of Florida. - Read More