Question

Check out the attached real options problem. In contrast to the official homework problem, this case is a cooperative venture.

Later in the week, after we have some solutions, I will attach an Excel spreadsheet that evaluates the alternatives: (1) take a direct equity interest now or (2) purchase an option to take a specified equity interest in the future at a specified price.

This use of real options is often employed by large technology companies that want to get in on the ground floor on (usually complementary) leading-edge technologies. These technologies may pan out or may be duds. The real options tool gives companies the upside potential of exploiting these technologies throughout their businesses if they work, but limits their losses if things don't work out. Firms sometimes have a separate organizational unit (an incubator?) to manage these investments, which can also take the form of direct equity investment or outright acquisition.

Answer 1

Real options typically give the company to adopt a technology later on. So firms can decide later on if they want to invest or not. If after a period of time, firms feel that the investment is not worth it, then they can decide to abandon it in future as the work on investment has not started yet.

Taking a direct equity investment now, however can be beneficial, as the company does not have the risk of losing out on an opportunity that it is getting now. However , the loss that can be faced by the company due to investing now, can be high.