Real Options Analysis has become a key management tool for many of today’s businesses. It is an accurate method for estimating the value of corporate investments, and it can be effectively utilised in situations where management has flexibility in large capital budget decisions with high uncertainties. It is not an equation or sets of equations but rather, an analytical process as well as decision analysis through process. Traditional DCF/NPV analysis discounts future projected cash flows to obtain a single point estimated present value. The basics of a DCF analysis assume a static and known set of future cash flows – which is rarely true.
In the real world, actual cash flows depend on many factors and may be above, below and at the forecast value line due to uncertainty and risk. The higher the risk, the higher the volatility and the higher the fluctuation of actual cash flows around the forecast value. When volatility is zero, the values collapse to the forecast straight line static value.
If a firm strategically positioned to take advantage of these fluctuations, there is value in uncertainty. Real Options Analysis also provides trigger points and optimal timing (i.e. optimal timing to execute).
Real Options are crucial in
No wonder many fortune 500 companies with large capital investments under risky business environments quickly adopt our methodologies in their business.
A multinational auto manufacturer has excess raw materials and multiple global vendors with minimum contractual obligations. Essentially, the manufacturer holds an option to switch using cheaper resources, or manufacturing flexibility due to uncertain global markets and legal requirements - option to hedge price and political risks. How much premium should be paid to obtain such flexibility?
Computer manufacturer that needs to produce accurate production forecasts months in advance. However, demand and price changes rapidly and forecasts are seldom correct so there is a high cost of inventory holding. The manufacturer can make investments on supply management and on demand flexible production systems enabling the company the option to wait and defer making decisions too early. What is the optimal timing of implementation and amount of investments to achieve optimal risk/return objectives?
Not all R&D projects will materialise due to uncertainty of success. There could be many factors affecting the likelihood of success of these projects. Having multiple concurrent R&D projects and stage investments provides an option to abandon some projects to ensure the overall success and survival of the products. What is the optimal cost of having such option available, and what is the optimal timing and threshold to abandon unworthy projects?
A project costs more than others due to the flexibility it offers to the business. Should this project be considered even though the costs are higher? Traditional NPV/DCF capital investment decision analysis would discount this project. However, these traditional analyses rarely produce accurate picture on the true value of these projects as they are incapable of taking into account of future risks and business flexibilities. As a result, poor decisions were often made due to inaccurate information.