OPPapers.com

Real Option

Real Options Overview
Business is beginning to recognize the value of real options analysis as demonstrated by
at least three recent articles on this topic in the Harvard Business Review (Dixit and
Pindyck, 1995; Luehrman, 1998a,b). Moreover, the non-telephone utility industry and
many other industries facing decisions on R&D spending, project/asset evaluation,
mergers, acquisitions and other investments have utilized real options valuation for
years.
1. WHAT ARE REAL OPTIONS?
The traditional approach to project evaluation and investment decisions uses discounted
present value (DPV) or discounted cash flow (DCF) methods. These methods explicitly
assume the project will meet the expected cash flow with no intervention by
management in the process. All the uncertainty is handled in the (risk-adjusted) discount
rate. This process is static. At most, the expected value of the cash flow is incorporated
into the analysis.
Management’s flexibility to make decisions as states of nature are revealed is assumed
away by this methodology. However, management discretion has value, which is not
incorporated into the DPV. The real options methodology goes beyond this naïve view of
valuation and more closely matches the manner in which firms operate. It allows for a
firm’s flexibility to abandon, contract, expand or otherwise modify its actions after nature
has revealed itself. This is the first lesson for policymakers – if they wish to emulate the
competitive process, they cannot rely on the application of naïve DCF methods in cost
models.
Decision-tree analysis (DTA) moves the analysis one step forward by allowing that
alternative states of nature are possible. But, as in the case of DCF, the appropriate
risk-adjusted discount rate is virtually indeterminate.1 Using the firm’s opportunity cost of
capital is inappropriate if the project does not correlate with the company’s cost of capital
— another lesson for the telecommunications industry. Unbundled...