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The Real Options Theory Essay

2150 words - 9 pages

The Real Options Theory

05/14/2012

The Real Options Theory

Introduction

The real options theory has become a vital tool for companies that are thinking of making an investment. The real options theory provides a set of analytic tools that evaluate and deal with the ambiguity that permeates strategic decisions. It requires research to make predictions of financial stability and it also exclusively posits a payoff structure for investments with fixed options by suggesting that real options enable companies to reduce downside risk while accessing upside opportunities. Compared to other ...view middle of the document...

Because of these options, management can maximize its potential while limiting losses (Westerfield, Jaffe & Jordan, 2009).

Reason for Use

The theory of real options arose because of corporate dissatisfaction and those using capital budgeting techniques, because it was noted that discounted cash flows lacked in flexibility (Tong & Reuer, 2007).While the old-fashioned approaches are valued, and they do not take into account for the reality of the situation or the variations that could occur. Techniques such as discounted cash flow approaches and net present value method have proven to imprecisely represent the outcome of the investment because it does not allow for flexibility in the plan. Without real options, the company cannot modify their strategies for the fear of disregarding the original proposal. Early critics recognized that standard discounted cash flow criteria frequently undervalued investment opportunities; this in result, lead to loss of potential investment, and this caused companies to lose their competitive edge. Corporate management frequently did not properly value flexibility and change. Supporters of the real option theory have argued that the problem arises from misuse of the discounted cash flow techniques, so in response they proposed a solution to the lack of management flexibility in order to restore competitiveness by developing specific options to be viewed as an organization for acquiring and managing real options (Tong & Reuer, 2007).

Usage in Conjunction

The discounted cash flow technique relies on discount rates that regularly vary over time, with different components of the cash flows, real option theory in response helps estimates the market value of a project to do so it requires a good estimate of the net present value and the future earnings. If this information cannot be obtained or estimated fairly, this causes the real options theory to become less relevant. In some situations management must make the choice of which method to use. Real options are a good choice if the analysis is intended to estimate the market value of the project or decision and if the fundamental asset value and prospective earnings can be estimated accurately (Tong & Reuer, 2007). Discounted cash flow analysis is a good alternative if relinquished earnings cannot be estimated, but market valuation remains the goal and risk remains relatively constant (Tong & Reuer, 2007). This is not to say that discounted cash flows, such as the net present value, should be discounted. Instead it should be used in conjunction with real options.

Although the discounted cash flows techniques can help a company create ideas and then implement them, without real options the company is unable to alter that decision therefore, the discounted cash flow is best practical when the outcome or cash flows are known with confidence. Given that certainty is not always the case, real options are...

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