Real Options

Real option is an alternative that becomes available with a business investment opportunity. Unlike the option which is a derivative of an underlier, real option is an actual choice that a business may gain by undertaking certain serious effort. They are referred to as "real" because they usually pertain to tangible assets, such as capital equipment, rather than financial instruments.

For example, by investing in a particular project, a company may have the real option of expanding, downsizing, switching or abandoning other projects in the future. Other examples of real options may be opportunities for R&D, M&A, and licensing.

Unlike financial options, real options are usually not tradeable. For instance, an option to build an additional building is not a tradeable option. Only the manager responsible for making the building decison can exercise this option. It can not be traded.

Few real options are tradeable, such as a piece of land that is owned by a company. Land has the potential for development in the future and it can be sold to another party.

Some real options are owned by a single company whereas others are owned by multiple companies. The real options which are owned by a single company are exercisable by only that particular company whereas the real options which are owned by multiple companies can be exercised by many parties.

Choose option or option to Change (switch inputs or outputs)

This option is analogous to the option to alter operating scale. It pertains to the imprecision of expectations regarding the type and cost of inputs and outputs. Imbedded options to change are essential ingredients in long life machines used for fashion goods, for instance.

This type of option has the following characteristics
• Option to switch use of inputs
• Option to switch output matrix
• Flexible production technology option

The choose or switching or flexibility option allows managers to switch inputs in a manufacturing process. An example would be modifying power-generating systems to permit switching between coal, oil and gas depending on their costs. It generally costs more to build flexible plant up front but input flexibility can pay for itself rapidly if input process is volatile.

The option to incorporate a greater degree of fluctuation / flexibility into a company’s operations, especially manufacturing & production. It generally includes the opportunity to design the manufacturing & production process to accept multiple inputs, use flexible manufacturing techniques / technologies to create a range of outputs by reconfiguring the same set of plant and equipment to face fluctuations both in input and output demand reducing long lead times in building new capacity from the ground up. A financial modeling and analysis exercise that recognizes this option embedded in a capital expenditure should be able to increase the NPV of a project.

More information is available in the file enclosed.


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