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Use of Real Options Theory in Financial Management

Explain the Use of Real Options Theory in Financial Management/Modeling. Identify the main issues, specific current and future applications, and relevance to the workplace.

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The real options theory has become an important tool for companies that are or are considering investing. While the traditional methods are valuable, they do not account for the actuality of the scenario or the changes that could occur. Discounted cash flow approaches, such as the net present value method, have proven to inaccurately depict the outcome of the investment due to not allowing flexibility in the plan ("Real Options," 2008). Without real options, the company cannot alter their strategies for fear of discounting the original proposal.

The theory of real options arose because of corporate dissatisfaction, and those using capital budgeting techniques, with the discounted cash flows lack of flexibility (Tong & Reuer, 2007). Early critics recognized that standard discounted cash flow criteria often underrated investment opportunities (Hayes & Abernathy, 1980). This resulted in loss of potential investment, as well as competitive position. Corporate management or their analysts did not properly value flexibility and change. Proponents have argued that the problem arises from misuse of the discounted cash flow techniques. Balden and Trigerogis (1993) proposed a solution to the lack of management flexibility in order to restore competitiveness by developing specific options to be viewed as an infrastructure for acquiring and managing real options.

The real options theory begins by comparing the similarities between real options and financial options. Real options give the holder the right, but not the obligation, to buy or sell the asset at a specified price on or before a given date (Tong & Reuer, 2007). The notion of real options was developed from an idea that a corporate manager can view the company's discretionary investment opportunities as a call option on real assets (Myers, 1977). It is a given that companies often face change, improbability, competition, doubt and budget adjustments. With that in mind, companies cannot readily depend on discounted cash flows. Instead they can choose to defer, expand, contract, abandon or alter the project while using real options (Westerfield, Jaffe & Jordan, 2009). Because of these options, management can maximize its potential while limiting losses (Baldwin & Clark, 1992). 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.

Consider a logging company. The company can choose to log the timber now or choose to wait. Calculating the net present value is helpful in calculating prospective cash flows, but real options consideration allows the company to account for "what if" situations. It can be very valuable to wait unless of course a competitor is ready to capture the market out from under your hands (Westerfield, Jaffe & Jordan, 2009). Although there may be a cost of waiting, it allows the company to take a more researched route, thus producing greater profits. If the company is uncertain about the outcome, the value of waiting is greater.

The real options theory provides a set of analytic tools that evaluate and deal with the uncertainty that permeates strategic decisions. It requires research to make predictions of financial stability. It also uniquely posits a payoff structure for investments with fixed options by ...

Solution Summary

This solution explains, in detail, the use of real options theory in financial management. Includes 9 references.