Abstract
Of late, experts have expressed concerns over alleged inefficiency of traditional cash flow models such as discounted cash flow model in capturing the value of the options entrenched in most actions of the corporate. According to the experts mainly academics and practitioners, the options need to be valued and considered explicitly since their value can be significant. Real options when considered can help in adding value to most acquisitions and investments that would otherwise be invalid. Though many actions have real options entrenched in them, there are conditions that must be met for real options to be valuable. To allay the shortcomings of traditional cash flow model, real options theory is used instead. An example of such problems is where a project’s net present value fails to capture the values of the options to expand, delay or even abandon an ongoing project (Baker etal, 2011). Also, discounted cash flow valuation model does not consider other options that a company may own such as rights to natural reserves, patents and licenses. Moreover, it fails to measure the option to control and liquidate a company owned by shareholders. Other strategic options open for consideration by an acquiring firm are often ignored during valuation. Real options dominate every aspect of decisions made by business managers. However, it would be prudent to understand what conditions make them to be valuable.
Introduction
Real options refer to a relatively new financial analytical tool that helps investors and managers to select market valuations that reflect a blend of businesses that are already known together with the value of business opportunities that are likely to arise. The Black-Scholes model is one of the best known forms of financial option theory that is applied through real options. There is need for managers and investors to understand how to take advantage of rapid changes that are occurring in economic world. This need if fulfilled by real options which gives them requisite insights into strategic investments and businesses.
Real options are viable where particular conditions are met. Managers who are keen on maintaining the status quo will certainly miss the opportunities availed by this analytical tool. Economic changes occurring from time to time are a fertile breeding ground for real options. Businesses with adequate capital, reputable and intelligent management are more likely to fare well with real options. This is so because such managers will be capable of identifying, understanding and creating real options and eventually put such knowledge into practice. Businesses that enjoy economies of scale are highly likely to benefit from real options since they have access to richest opportunities and best information (Karami and Farsani, 2011). By juxtaposing real options to the traditional valuation model, an investor can fully appreciate the power of this analytical tool.
Real Options versus Discounted Cash Flow Model
Real options being an extension of financial option theory brings into consideration things such as options that are not related to finance in any way or options that are real. Real options give a company the right but not the obligation to create an investment whose value is likely to increase. Examples of such investments include licensing agreements, new plants, joint venture and line extensions (Luehrman, 2011). Contrary to real options, financial options give the right and not the obligation to its owner to buy or sell a security at a stated price. Real options complement discounted cash flow by availing an element of analytical flexibility that makes it possible to combine strategic intuition and analytical rigor. The real option theory is as valid as it can be since it heavily relies on with common day to day data obtained from financial markets.
Real options make it possible to contract, expand, defer or abandon an investment as opposed to DCF model commonly known as net present value rule (NPV) which does not consider the element of uncertainty. Thus, real options are much flexible since they offer a broader view. Sagner (2007) states that “Unlike NPV which does not support decisions made for the future, real options make it possible to deal with a situation where future investments are tied with success of today’s investments.” A good example is investments made in a pharmaceutical company which enables investments to be made in stages when spending for future development of a drug.
Real options unlike DCF enable investors to value the unknown. In real options, investments with high option value are those with greater uncertainty like internet industry. DCF accords low net present values to such investments with high discount rates due to high degree of uncertainty. With this in mind, it becomes obvious that though DCF model is capable of valuing traditional businesses, it is not flexible enough to value upcoming business opportunities like the internet. Being a complement to DCF, real options adds the very much needed flexibility in today’s ever changing economic world thereby enabling investors and managers make proper financial and strategic decisions. It helps curtail uncertainty that may overwhelm business decision makers due to technological changes that keep taking place. According to Mauboussin (1999), “real options allow business intuition and analytical rigor to thrive and exist side by side.” It enables the management to gauge future corporate value.
Benefits of using Real Options
Real options are applied in a quantitative and formal way to make decisions on investment projects whose level of uncertainty cannot be established. According to this theory, economic changes taking place as a result of technological flexibility can add value to a company. DCF model only give recommendations which do not acknowledge the value of growth opportunities that can aid in strategic decision making.
The real option framework helps investors determine the right time to enter the right market based on technological changes. A company can increase its absorptive capacity by investing early in promising technology (Van Putten and Macmillan, 2004). According to Krychowski and Quelin (2010), “Technological complications cause high level of uncertainty and problems arising due to this can be avoided by adopting innovations early enough. These simulate processes that may help a company to make similar choices.”
In a nutshell, real options help the management to make informed decision when determining appropriate time to enter right market. Managers are able to balance rewards and risks of delaying market entry. It also helps to improve dialogue between all players involved in a project. Moreover, if a project proves to be impossible then the stakeholders can choose to abandon it all together. It also improves the ability of the stakeholders to launch an alternative project in case of failure. Since not all investment decisions qualify to options, there are certain four conditions that a decision must satisfy in order to merit application of real option logic. These conditions include uncertainty, revelation of information, uncertainty and irreversibility. Where low degree of irreversibility and uncertainty is evident, then it would be appropriate to use DCF model.
Discussion
Theoretical attractiveness of real options has not attracted much attention from mangers as anticipated. This is because there is this belief that real options encourage companies to overinvest in uncertain projects whose value has been overestimated. Indeed, overambitious managers have ended up gambling with stakeholders hard earned cash. The mutual reluctance to comply is especially prevalent among small to medium business managers due to suspicion that this tool is feasible where the company in question is dealing with complex business projects and have well defined financial options (Sagner, 2007).
The foregoing class of managers alleges that the numerous simplifying assumptions deprive them off the ability to comprehend some of the risks and opportunities proposed in a project. Though these concerns are valid, the role played by real options cannot be overlooked. This is because the danger of underestimating the value of projects and therefore not investing in them is ever present especially when a manager has to use discounted cash flow analysis. The solution to this dilemma lies in the managers’ ability to integrate the two approaches in valuations for their business projects.
Conclusion
Real options are known to yield outstanding results when use to evaluate investment projects. During initial stages of evaluation, managers who choose to apply real options to NPV rule or DCF abandon a project if it fails. Abandoning a project before completion enables sunk costs to be recovered. Though real options method is efficient compared to traditional models, it would be prudent for managers to use both models hand in hand for improved efficiency.
Bibliography
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