Question

Discuss the valuation content of growth opportunities in a real options context.

Answer 1

A real option is a modern theory as compared to traditional capital budgeting theory. Real option refers to options hidden inside project. The popular varieties are :

Timing option : Right to start a project sometime later (Call option)

Abandonment option : Right to abandon i.e. right to sell a project in between. (Put option).

Follow-on-investment : One projects gives us the right to enter another project sometimes later.

The underlying asset in real option are tangible and human assets like plant & machinery, land & building etc. rather than financial securities. Real option includes the decision to expand, defer or wait or abandon the project.

A strategic implication of real options theory is that investment will be discouraged by exogenous uncertainty. For this reason, the timing of an investment can be crucial in determining its profitability. Another aspect of real options can be found in abandonment. The abandonment options comes into play when a firm purchases an asset that it may later resell or put to an alternative use, should future conditions be sufficiently adverse. Availability and recognition of this option will increase a firm’s propensity to invest relative to what would be suggested by a simple NPV rule, which assumes that the investment project continues for its physical lifetime and omits the possibility of future divestment.

The real option creates economic value by generating future decision rights specifically, by offering management the flexibility to act upon new information such that the upside economic potential is retained while the downside losses are contained. Project with real option can be evaluated using a range of possible profits.