With conventional NPV, risks and uncertainties related to the project are accounted for in the cost of capital, through attaching probabilities to discrete outcomes and/or conducting sensitivity analysis or stress tests. Therefore, where an organisation has some flexibility in the decision that has been, or is going to be made, an option exists for the organisation to alter its decision at a future date and this choice has a value.
Real options build on net present value in situations where uncertainty exists and, for example: (i) when the decision does not have to be made on a now or never basis, but can be delayed, (ii) when a decision can be changed once it has been made, or (iii) when there are opportunities to exploit in the future contingent on an initial project being undertaken. The real options method estimates a value for this flexibility and choice, which is present when managers are making a decision on whether or not to undertake a project. It does not recognise that most investment appraisal decisions are flexible and give managers a choice of what actions to undertake. Therefore it assumes that a decision has to be made on a now or never basis, and once made, it cannot be changed. The conventional NPV method assumes that a project commences immediately and proceeds until it finishes, as originally predicted. The second article considers a more complex scenario and examines how the results produced from using real options with NPV valuations can be used by managers when making strategic decisions. The article then considers the limitations of the application of real options in practice and how some of these may be mitigated. This article discusses real options and then considers the types of real options calculations which may be encountered in Advanced Financial Management, through three examples. This is the first of two articles which considers how real options can be incorporated into investment appraisal decisions. Real options’ valuation methodology adds to the conventional net present value (NPV) estimations by taking account of real life flexibility and choice.
Real options valuation professional#
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