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Companies often have to increase their initial investment costs to obtain real options such as Abandonment,...

Companies often have to increase their initial investment costs to obtain real options such as Abandonment, Timing, Growth & Flexibility. Why might this be so, and how could a firm decide if it was worth the cost to obtain a given real option?

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Answer #1

Many a times, one doesnt know the market perfectly well and in those cases one would be stuck with initial capacity or production if the demand is not as high as was anticiapted. Also, one can lose out if it is not able to expand in the case of demand being more than anticipated. Hence, company needs real options which provides them the rights but do not obligate them, for uncertainty, to give significant flexibility for changing the course of project in favorable direction.

THe firm can do a scenario analysis by calculating the NPV in those scenarios and then would be able to tell whether the cost was justified or not. Investment opportunities can be plotted in "option space" with dimensions such as "volatility" and value-to-cost ("NPVq")

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