Real Options Analysis was developed as an extension of Options Theory and is used in the area of Finance as a method for evaluating decisions. An ‘option’ is the right, but not the obligation, to purchase a share of stock at a future date, for a predetermined price.
For example, as part of its remuneration package, a company may offer its employees the option to purchase shares in the company at a later date, for the current market price. Employees will buy these shares if their value at the specified point in the future is greater than the agreed upon purchase price. The advantages of doing so are evident, since these shares could be sold immediately for the current market price, resulting in risk-free profit to the employee. They will choose not to purchase if the value has dropped below the agreed purchase price, because this effectively results in an immediate reduction in their net assets.
When the option to buy can be exercised on only one particular date, known as the ‘expiration date’, this is a ‘European’ option. In contrast, an ‘American’ option may be exercised at any point up to and including the expiration date.
In summary, an option allows an investor to delay the decision of whether or not to invest and, if it is an American option, also allows them to decide when to invest. The flexibility inherent in capital investment can be approached in the same fashion, and the application of financial option valuation techniques to capital investment decisions is known as Real Options Analysis.
The Value of Flexibility
In uncertain environments, it is desirable to have as much information as possible before committing to a decision. For this reason, organisations often choose to delay investment decisions until some of the uncertainty surrounding these decisions has been resolved. Before Real Options Analysis was developed there were decision-making tools that considered risk and uncertainty, such as Expected Net Present Value. These methods tended to ignore the inherent flexibility in the decision-making process relating to start time and the rate at which investment occurs. The merits of allowing flexibility in decision-making were recognised and the fact that none of the decision-making tools in use could accurately value such flexibility led to the development of Real Options Analysis.
Real Options Analysis is a method for evaluating investment decisions, which can take the flexibility of being able to delay a decision into account by placing a value on this flexibility. A real option is the right, but not the obligation, to implement an investment decision at one or more points in the future. There are four main types of investment decisions covered by Real Options Analysis, namely the ability to expand, delay or abandon a project, and the ability to vary the inputs or outputs of a production process. The client’s meter installation problem is a situation where the option to delay is considered with regard to the start-time of the installation program. Also, a variation of input resources to adjust the rate of installation will be important. Stochastic dynamic programming is a modelling framework that will handle both of these issues.
Real Options Analysis Applied
Often, in capital investment decisions, the price of the investment can be reasonably predicted, but the benefits from acquiring the asset are harder to assess. In this problem, the price of the smart meters is expected to decrease over time in a predictable manner. The actions of the client’s competitors have a substantial effect on the benefits they will gain from the investment, and since these are difficult to predict, the value of the new meters is uncertain.
The value will be high if the client is the first to implement this technology, but will be considerably lower if one of their competitors acts first, due to lost market share and, therefore, potential revenue.
Real Options Analysis suitably models the trade-off that exists in this problem between delaying investment to take advantage of reducing costs, and losing market share and possible income streams as a result of delaying too long.
For more information on Real Options Analysis, see here.