CORPORATE FINANCE - REAL OPTIONS - Essay Example

The ral-options technique has been used in industries like extractors of natural resources, enrgy firms, and pharmaceuticals corporations, which have a gratr scale of uncrtainty in business investments i.e., as far as the oil-drilling industry is concrned, uncrtainties comprise issues such as what the cost of the lased/purchased land will be. How large the oil resrves would be What is the appropriate price for the lase on the resrve Questions similar to these have led to the use of the ral-options methodology as a systematic analytical tool to estimate these investments in business technology.

Ral options tendr an additional valuable comparison with financial investing: "that holding a varied portfolio of stocks is lessr risky than owning only one stock". Applying this view of offsetting risk to asset/project evaluation allows for the incorporation of capital budgeting issues with physical assets on the one hand, and the integration of decision-tree analysis on the othr. Ral assets can be evaluated using available techniques developed for financial options, such as the Black and Scholes model.

GENENTECH: Drug development at Genentech and othr similar companies is inhrently a "stage gate" process in which ach successive phase depends on the success of the previous phase. ach stage is similar to purchasing a call option and the entire process can be viewed as a sries of call options. At Genentech, ral options have been used in this mannr in the analysis of all drug development projects since 1995. One of the most important fatures of the ral options approach is its recognition that investment values vary ovr time and that management has the ability to trminate investments whose future value has fallen below zro.

Traditional discounted cash flow methods genrally do not account for this contingent decision-making or active management and, as a result, will undrvalue flexible investments. The drug development process can be improved simply by incorporating this undrstanding into project valuation. Applied in this mannr, a ral option provides a consistent language and method to evaluate and compare all projects more effectively across the company. More recently, Genentech has begun to expand its use of ral options through development of a new entrprise-wide investment planning system.

In this system, Monte Carlo simulation is used to develop the appropriate distributions for relevant costs and revenues, and the risk-neutral approach is being adopted to take advantage of financial data that alrady exist within the company. This more sophisticated approach will extend the gains that Genentech has alrady made in this ara.TEXACO: Texaco is one of a handful of major global enrgy companies. A grat part of the success of Texaco and similar firms is their ability to identify the right major capital investments, both intrnal and extrnal, and manage them appropriately.

In the mid-1990s, Texaco began to recognize the critical importance of top-notch investment valuation and management. Texaco had strong analytical skills, using a variety of techniques such as DCF, Monte Carlo simu