Real options and investment decision making 6 assumes that the investment decision is a takeitorleaveit decision at that moment in time. Introduction to real options we introduce real options and discuss some of the issues and solution methods that arise when tackling these problems. This paper expands the selections of investment decisions for the project using. It strikes a superb balance between solid intuition, rigorous analysis, and numerous practical examples. This report introduces real options as a key addition to the valuation toolbox. Robert pindyck mit lectures on real options part i august, 2008 2 44. Evidence of practical application of real options analysis 4. What is real about real options nfinancial options can be valued using arbitrage arguments replicate payoffs using dynamic portfolio of traded underlying assets and riskfree bond since portfolio payoffs are equivalent to option payoffs in each state of nature, price. In this essay, we study the capital budgeting method called real options analysis. Tools andtechniques forvaluing strategic investments and decisions. Tools and techniques for valuing strategic investment and decisions, 2nd edition mun, johnathan on. Another problem, once again more academic, is that the real options are investigated according to the financial options lens far too often.
Real options are relevant to only to the subset of strategic options in which the exercise decision is largely triggered by marketpriced risk. We begin by offering a few caveats on the application of option pricing models to these cases and suggesting some adjustments that might need to be made to these models. Issn 20080050 print, issn 19270097 online differences. Real options is the term used to refer to the application of option pricing theory to the valuation of investments in nonfinancial or real assets where much of the value is attributable to. Real options offer a great way to wed strategic intuition with analytical rigoran increasingly important issue given the pace of economic change. Marine studies marine institute of memorial university of. The cases in the real options analysis course provide numerous examples of how the use of real options and the real options toolkit software can assist in the valuation of strategic and managerial flexibility in a variety of arenas, with many practical and useful examples. Real options, agency conflicts, and financial policy pdf. The objective probability the market will go up is 20%.
Real option analysis example 1 a company is considering investing in a project. Mun demystifies real options analysis and delivers a powerful, pragmatic guide for decisionmakers and practitioners alike. Application of real options analysis for pharmaceutical r. A situation in which an investor is able to choose between two different investments where both choices involve tangible assets. The first is that real options cannot be easily valued, since the inputs are difficult to obtain and often noisy. The process of roa can assist in leaving investment options open, thereby enabling the investor to explore other potentially riskier possibilities.
Johnathan mun, phd, is currently the ceo of real options valuation, inc. Modeling risk applying monte carlo simulation, real options analysis mun 2006. Muns new book is a refreshing, cuttingedge look at a powerful new decisionmaking process. Thus, dcf analysis and real options analysis can play a complementary role to each other. It is the right but not the obligation to acquire the gross present value of expected cash flows by making an irreversible investment on or before the date the opportunity ceases to be available. Pdf real options and monte carlo simulation versus traditional. Naval postgraduate school california and the university of applied sciences switzerland. Real options complement the standard discounted cash flow approach and add a meaningful. A real option refers to the decision alternatives available for a tangible asset.
Finally, there is a book that equips professionals to easily recognize, value, and seize real options in the world around them. Realoption approach the realoption approach is generally considered an extension of financial option theory applied to investment options on real nonfinancial assets. More precisely, through the aim of the project, a tool is elaborated which allows the inclusion and analysis of. Millionaire traders how everyday people are beating wall. When buying clothes there is an option to wait for the back to school sale. These real options models are like extreme sports that looks impressive but are hardly something that could be applied in a real business setting. Real options analysis provides a revolutionary approach to evaluating and valuing capital investment strategies by taking into consideration the real options inherent in the strategic decisionmaking process. An analysis based on real options would instead focus on the range of profits and losses that may be encountered over the course of the investment period as the price of oil changes over time. May 02, 2020 real options analysis roa is a term in finance that primarily applies to an option to craft, dump, inflate or minimize a capital investment. In the 1970s and the 1980s, developments in the valuation of capitalinvestment opportunities based on options pricing. We go on to demonstrate the power of realoption valuation as compared with traditional npv analysis.
Real option analysis, decision analysis, marketed asset disclaimer. Marine studies marine institute of memorial university. Heres an approach that not only makes the math of options easier but also helps you make better decisions about exercising them. A business can use the real options concept to examine a range of possible outcomes, and then make a choice based on this broad set of alternatives. The analysis of the possible functions of real options to improve the valuation of companies also provided insight on the. Real options are applied where an investments behavior can be reasonably tracked by traded assets. Real options reasoning ror is a conceptual approach to strategic investment that takes into. More specifically, the real options analysis course presents numerous real options examples and provides the reader with stepbystep problem solving techniques.
For example, a traditional investment analysis in an oil refinery w. New sources of data for real options analysis sarah nelson, naval postgraduate school thomas j. The promise and peril of real options nyu stern school. Intersectoral level until the end of the old millennium several international companies e. Two category a electives plus one category b elective. Abstract perhaps the primary unresolved real options research problem is still how to develop defensible model inputs. This has potentially significant implications for the construction industry in developing countries. Real options analysis financial definition of real options. The appropriate riskadjusted rate of return cost of capital is 25%. Citeseerx document details isaac councill, lee giles, pradeep teregowda. Teixeirab a institute for applied economic research of the brazilian government ipea. Mun demystifies real options analysis and delivers a powerful, pragmatic guide for. Among practitioners, however, the method has not had a large breakthrough, although it has existed for almost three.
What links here related changes upload file special pages permanent link. Real options analysis roa is a term in finance that primarily applies to an option to craft, dump, inflate or minimize a capital investment. Real options analysis seeks to value such flexibility both the flexibility embedded within the investment opportunity eg expand, contract etc. Real options analysis expands the concept of npv to include these factors, and provides a more accurate estimate of value for virtually all corporate investments. Real options analysis tools and techniques for valuing strategic. In this paper, the use of real options analysis to evaluate and guide new aircraft development programs is illustrated through a case study of a realworld aircraft program. The present value pv of future discounted expected cash flows is either 3000 if the market goes up or 500 if the market goes down next year. Potential applications of real option analysis in the. This contains many of the features typically found in real options applications a non nancial setting, some nancial uncertainty. Real options are a useful tool to guide a firms strategic planning, and can create or enhance a firms value. The analogy is often presented in a table format that links the. Feb 17, 2006 mun demystifies real options analysis and delivers a powerful, pragmatic guide for decisionmakers and practitioners alike.
Real options sls is a standalone software and spreadsheet accessible. Carlo simulation for financial risk analysis and real option valuation. Real options are not just about getting a number, they also provide a useful framework for strategic decision making. Tools and techniques for valuing strategic investments and decisions. There will be two arguments made against this requirement. Expiration date european or american form basic options call option put option financial options real options complex options contingencies option created by some earlier action interdependencies options with interdependent values 2000. Praise for real options analysis, first and second edition this book is a musthave and mustread. Valuing corporate growth using real options semantic scholar. With offices in north america, europe, australia, and asia, wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding.
The method is, by many researchers, considered superior to other capital budgeting methods since it is able to value exibilities within projects. Our main example is the simplico gold mine example from luenberger. An american option allows you buy or sell the stock at any date between the present and the exercise date. The analysis of the possible functions of realoptions to improve the valuation of companies also provided insight on the.
Real options valuation, also often termed real options analysis, rov or roa applies option. Real options valuation, also often termed real options analysis, rov or roa applies option valuation techniques to capital budgeting decisions. Real option valuation is often presented to be analogous with financial options valuation. Mun s new book is a refreshing, cuttingedge look at a powerful new decisionmaking process. Many of these are considered to be obvious and other requires more thought. Real options are a complement to, not a substitute for, discounted cash flow analysis. Kutilitilaka 1999, copeland and antikarov 2001 and mun. Real options in telecommunications strategis partners. Muns latest book is a logical extension of the theory and application presented in real options analysis. The analysis provides clear evidence that investors can use the numerical results of the real options analysis to. According to mun, 2002 in the discrete time steps of the real option valuation lattice. Referring to this data, some authors have already announced the real options revolution coy, 1999. Real options analysis 1 motivating example example 1 a manufacturer is considering a new product line. Run real options analysis, monte carlo simulation, forecasting, and optimization, coupled with a set of 12 training dvds playable on home computers and dvd players.
Real options, real options analysis, investment, investment analysis, developing countries. Oct 03, 2002 real options are a useful tool to guide a firms strategic planning, and can create or enhance a firms value. Using real options for decision making accountingtools. Then money could be saved if so is chosen and the option to wait has a value. A real option is a choice made available with business investment opportunities, referred to as real because it typically references a tangible asset instead of financial. As noted earlier, the 2nd edition of the valuation text by copeland, koller and murrin makes a strong case for the classic approach and the importance of finding a. There are three possible, equallylikely market states. Transformation of scenario planning into a real options valuation. Real options reasoning ror is a conceptual approach to strategic investment that takes into account the value of preserving the right to make future choices under uncertain conditions. Through real options analysis but not formal option valuation, nif managers were able to assess the cost effectiveness of their options at each stage. The essence of real options to understand the basis of the real options argument and the reasons for its allure, it is easiest to go back to risk assessment tool that we unveiled in chapter 6 decision trees. Pdf this chapter provides a contrast between traditional valuation. Prior to starting his own firm, he was the vice president of analytics at decisioneering, inc. A real option itself, is the rightbut not the obligationto undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project.
Johnathan mun and his worldwide collaborators risk managers. Valuation of real options as competitive prototyping in system development. While financial options are detailed in contracts, real options are embedded in strategic investment projects and can have a substantial impact on the final project value. To pick the best growth projects, managers need to use the two methods in tandem. Real option strategic decision trees analysis compiled by ted fu july 1, 2002 adapted from. After having read the book, readers will better understand the.