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Option Theory in Finance Essay

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Updated: Dec 26th, 2019

Introduction

Opportunities are options. No one is obliged to take an opportunity. Every endeavor in life and business is deciding to take or leave an opportunity. Thinking of investment decisions as options ultimately changes the hypothesis and norms (of decision-making).

The customary methods of management advise that the investment decision made cannot be reversed if the prevailing or expected outcome changes. As soon as we change the mindset and look at investment decisions differently, the premise of decision-making totally changes.

Importance of the option theory

The issues of uncertainty and irreversibility and the timing can alter the outcome of our decisions. The option theory in its own way tries to bridge the shortcomings of the conventional methods of investment decision making. A number of investments are uncertain and irrevocable. They are also capable of postponement.

Delaying an investment will undercut its net present value (NPV). In a commerce contractual relationship, the investor approaches projects with an ideal outcome in mind. The investor focuses on what is real and possible with both partners in the contract looking forward to the desired results.

Once the investor has signed the contract, it implements its call option. After a company has exercised its option thereby making it irreversible, the company terminates its option. By exercising an option, a company surrenders them to the vices.

Any new information that can influence the attractiveness of opportunity is no longer useful. Since the lost option signifies an opportunity cost, it is taken as part of the cost of investment.

The opportunity cost is susceptible to uncertainty over the cost and value of an investment; therefore, future economic conditions that may shape the perceived risk of expected cash flows can have a large impact on investment expenditure.

The major problem with NPV analysis is that it fails to recognize the importance of creating options. Options enable the company to embark on other investments in the future, since it allows managers to view opportunities in isolation.

Option cost has significant implications for managers as they reflect about their venture decisions. Case in point companies often finds it beneficial to delay investment decisions and wait for more insight about the future market environment, even though analysis show that it is the venture is viable at present.

Furthermore, there are circumstances in which uncertainty over the expected market conditions should inform the company to speed up investment.

Cases of irreversibility and uncertainty

One fundamental matter that the option theory puts across is the issue of uncertainty and irreversibility. Venture capital is irreversible when they specific to an industry or a company. Investment in advertising and marketing constitutes sunk costs. Another example of irreversible investment is a cement plant.

A cement plant can produce only cement. Other investments are irreversible. For example, when a buyer purchases a TV set, the decision to buy is irreversible. The buyer is not able to ascertain the quality of the device but he has no option but to accept it as it is.

Irreversibility can also arise due to government regulations or differences in corporate systems. For example, excise duty of export goods may be evaluated after a company has invested in the export industry.

The appreciation that capital venture decisions can or are irreversible gives the capacity to delay investments added advantages, although in most cases it is not practical to delay.

Uncertainty also plays a crucial role in the timing of capital investment decision. A small increase in uncertainty can cause delays in investment decisions.

Conclusion

The options theory applies financial options theory to quantify the value of management flexibility in an uncertain world. It enables managers to distinguish and communicate the strategic value of investment in a project.

Conventional methods such the net present value methods do not include the economic value of investment in a market of rife uncertainty.

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IvyPanda. (2019, December 26). Option Theory in Finance. Retrieved from https://ivypanda.com/essays/option-theory-in-finance/

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"Option Theory in Finance." IvyPanda, 26 Dec. 2019, ivypanda.com/essays/option-theory-in-finance/.

1. IvyPanda. "Option Theory in Finance." December 26, 2019. https://ivypanda.com/essays/option-theory-in-finance/.


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IvyPanda. "Option Theory in Finance." December 26, 2019. https://ivypanda.com/essays/option-theory-in-finance/.

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IvyPanda. 2019. "Option Theory in Finance." December 26, 2019. https://ivypanda.com/essays/option-theory-in-finance/.

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IvyPanda. (2019) 'Option Theory in Finance'. 26 December.

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