Shorena
Real Options
The standard net present values (NPV) analysis of capital budgeting values a project by discounting its expected cash flows at a risk-adjusted cost of capital. This technique is by far the most widely used technique for evaluating capital projects. However, standard NPV analysis does not take account of the flexibility inherent in the capital budgeting process. Part of the complexity of the capital budgeting process is that we can change our decision dynamically, depending on the circumstances.
Many of the most important decisions that firms make concern real assets, a term that broadly encompasses factories, mines, office buildings, research and development, and other nonfinancial firm assets. We will see that it is possible to analyze investment and operating decisions for real assets using pricing models developed for financial options. To illustrate how it can be possible to evaluate an investment decision as an option, consider a firm that is deciding whether or not to build a factory. Compare the following two descriptions:
* A call option is the right to pay a strike price to receive the present value of a stream of future cash flows (represented by the price of underlying asset). * An investment project is the right to pay an investment cost to receive the present value of a stream of future cash flows (represented by the present value of the project).
So we have:
Investment Project | | Call Option | Investment Cost | = | Strike Price | Present Value of The Project | = | Price of Underlying Asset |
This comparison suggests that we can view any investment project as a call option, with the investment cost equal to the strike price and the present value of cash flows equal to the asset price. The exploitation of this and other analogies between real investment projects and financial options has come to be called real options, which we define as the application of derivatives theory to the operation and valuation
The standard net present values (NPV) analysis of capital budgeting values a project by discounting its expected cash flows at a risk-adjusted cost of capital. This technique is by far the most widely used technique for evaluating capital projects. However, standard NPV analysis does not take account of the flexibility inherent in the capital budgeting process. Part of the complexity of the capital budgeting process is that we can change our decision dynamically, depending on the circumstances.
Many of the most important decisions that firms make concern real assets, a term that broadly encompasses factories, mines, office buildings, research and development, and other nonfinancial firm assets. We will see that it is possible to analyze investment and operating decisions for real assets using pricing models developed for financial options. To illustrate how it can be possible to evaluate an investment decision as an option, consider a firm that is deciding whether or not to build a factory. Compare the following two descriptions:
* A call option is the right to pay a strike price to receive the present value of a stream of future cash flows (represented by the price of underlying asset). * An investment project is the right to pay an investment cost to receive the present value of a stream of future cash flows (represented by the present value of the project).
So we have:
Investment Project | | Call Option | Investment Cost | = | Strike Price | Present Value of The Project | = | Price of Underlying Asset |
This comparison suggests that we can view any investment project as a call option, with the investment cost equal to the strike price and the present value of cash flows equal to the asset price. The exploitation of this and other analogies between real investment projects and financial options has come to be called real options, which we define as the application of derivatives theory to the operation and valuation