Real options approach assumes that companies have some choice regarding when to invest – their proposed project is similar to an option there is an opportunity, which is not an obligation, to approve it and go ahead.Īs occurs with financial options, the key question is when to exercise that option: certainly not when the company has no funds (the cost of investing is greater than the benefit). This is because the winning bidder was aware that as soon as some initial drilling was completed, the company could – on the basis of the new information gathered from that initial digging – stop the exploration or expand it. In petroleum exploration contract auctions, it is common for the largest bids to be greater than the net present value calculation. In an article on the San Jose University website – Real Options Theory – Thayer Watkins explains that NPV, however, makes no provision for possible modifications to the project once it is underway – real options idea fills that gap in the NPV deficiency.īy not making any provision for this flexibility of the project, NPV consequently does not fully value its potential advantages. In many cases, for large sunk cost like investment in offshore petroleum fields, is possible to consider only the timing option.” For most capital investment in petroleum industry, the timing is the main option to be considered. The higher the managerial freedom degree, the higher is the value of the investment opportunity. If it is greater than zero, NPV theory tells us to go ahead with the project.Īccording to Real Options in Petroleum: “In most real investment opportunities there are managerial flexibilities (real options) embedded into the projects. If the NPV is zero, it makes no difference to the company whether the project is approved or turned down. The expected cash flows are discounted at the capital cost for the company, and the results are added up.
NPV theory says that an investment project’s future cash flows are estimated, and if there is doubt regarding those cash flows, the expected value is determined. It modifies NPV (Net Present Value) theory of investment decisions. Real options theory is a major new framework in the theory of investment decision-making. In other words, the project is like an option: there is an opportunity, but not an obligation, to go ahead with it.” Real options theory – a new theory “Real options theory assumes that firms also have some choice in when to invest. “Traditional investment theory says that when a firm evaluates a proposed project, it should calculate the project’s Net Present Value (NPV) and if it is positive, go ahead.” The Economist’s glossary of terms has the following comment regarding real options theory: In theory, tangible assets (real assets) could be valued according to the same methodology. The investment choices we have with tangible assets are similar to those that exist with financial instruments. If you have financial options, you then have the freedom to make the best choices and decisions, such as where and when to make a specific capital investment. Real options theory is based on logical financial options in capital investments in the sense that they create a certain level of valuable flexibility. They do not include derivative financial instruments such as stocks or bonds.
The term ‘real’ means that it refers to a tangible asset and not a financial instrument.Įxamples of real options include determining whether to build a new factory, change the machinery and technology on a production line, decide whether to buy potentially lucrative oil fields and when to start drilling or pumping, etc. In the world of business, a ‘real option’ is a choice available to a company regarding an investment opportunity. The theory has become a popular theme in most business schools across the world, as well as the boardroom, especially within oil companies. Real options theory draws parallels between the valuation of the financial options available and the real economy.
#Real options valuation example how to#
Real options theory is a modern theory on how to make decisions regarding investments when the future is uncertain.
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