I believe many of the readers would have heard about options which are usually traded in financial markets. However, only a few of us know that the approach used for valuing financial assets can be a very powerful tool to value real assets. In many situations, the traditional Discounted Cash Flow(DCF) approach does not equip the leaders to take correct capital budgeting decisions.
This article explains how leaders can take advantage of the Real Options-based approach which essentially goes beyond yes and no answers.
Financial Options – A quick introduction
Options, as the name suggests, are rights but not the obligation to take a position on underlying assets. The position here means buying or selling on triggering of an event. The event is a price threshold. The threshold is called Strike or Exercise Price.
For ease of discussion, I will only consider two types of most used options – Call Option and Put Option.
A buyer of the Call option has a right to purchase an asset mostly equity shares of the company at a predetermined price called Exercise Price or Strike Price. These options are useful when the underlying asset increases above the Exercise Price.
On the other hand, a buyer of the Put option has a right to sell the asset at a predetermined Exercise Price or Strike Price. The Put options are beneficial when the underlying asset price falls below the Exercise Price.
The buyer of options benefit is net of the price difference and the price of the option paid to the seller of the call option.
Options in financial markets offer several advantages to traders and investors from diversification to flexibility and many of these advantages are reflected in the Real Options as well which are discussed subsequently.
Benefits of Utilising Real Options in Investment Decisions
Real options work in a similar manner as financial options but they are used with real assets or projects. More formally Real options refer to the option to invest or not invest in a project or real assets at a future date. The decision to invest is based on a change in market conditions or uncertainty, and the option gives the holder the flexibility to make the investment when it is most advantageous. The concept of real options, though very powerful, is rarely used by business managers and management consultants to evaluate investment opportunities and make strategic decisions. The concept of Real Options is especially powerful in making an investment decision or in the valuation of start-ups. Start-ups are by definition very risky owing to uncertainties involved in almost every facet of businesses. However, even most Venture Capitalists ( VC ) do not utilize this really powerful tool.
Real options can be used by managers to make investment decisions and pursue market opportunities in a similar fashion as the decisions in financial markets. Real options offer myriad benefits and can help business leaders in a wide range of scenarios from tapping opportunities which have large upside potential without large commitments to de-risking the business in times of uncertainty. A few of the key benefits of the Real Option are summarised below:
Flexibility: Managers can use real options to delay investment decisions until they have more information or market conditions have improved. This allows them to adjust to changes in market conditions and make better investment decisions.
Evaluation of Uncertainty: Real options can be used to evaluate the impact of uncertainty on a project’s expected cash flows. This information can be used to make investment decisions that are more robust to uncertainty.
Portfolio Diversification: Real options can be used to diversify a company’s portfolio of investments, reducing the risk of exposure to a single market or asset class.
Better Alignment of Capital and Opportunities: Real options can be used to allocate capital to the best investment opportunities, taking into account the value of those opportunities and the uncertainty surrounding them.
Risk Management: Real options can be used to manage the risk associated with investments. For example, a company can invest in a real option that gives it the right to abandon a project if market conditions change.
Valuing Real Options
Although I would not delve into the mathematics of options, I believe it may suffice for practitioners to appreciate how different factors affect the value of options. One should note that the value of the option is what an investor will get if she exercises the option. On the other hand, the price of the option is the consideration paid to the seller of the option.
The value of an option is affected by several factors, including:
Underlying Asset Price: The price of the underlying asset is the most significant factor that affects the value of an option. An increase in the price of the underlying asset will generally increase the value of a call option, while a decrease in the price will decrease the value. The opposite is true for put options.
Time to Expiration: The time to expiration is the amount of time until the option contract expires. The value of an option decreases as the time to expiration decreases, known as “time decay.” This is because there is less time for the option to be profitable.
Volatility: Volatility is a measure of uncertainty. Volatility refers to the degree of price fluctuation of the underlying asset. Higher volatility generally increases the value of options, as there is a higher likelihood of large price movements in either direction.
Interest Rates: Interest rates can affect the value of options, especially when the option is used to hold an underlying asset that pays a dividend. Higher interest rates can increase the cost of holding the underlying asset, decreasing the value of the option
Strike Price: The strike price is the price at which the option gives the holder the right to buy or sell the underlying asset. The value of an option is affected by the strike price, as the option is more valuable when the strike price is closer to the current price of the underlying asset.
The value of an option is determined by a complex interplay between these factors. Understanding the impact of each factor can help traders make informed decisions about their options trades.
How it is beneficial for the leaders?
The real options approach provides leaders and practitioners of business with a flexible and robust framework for making investment decisions and pursuing market opportunities. This can help them maximize returns, manage risk, and allocate capital effectively.
I hope you like this article and I would be happy to receive your feedback.
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best regards
Rohit Chaturvedi
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