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Real Options Theory in the Field of Adult Development

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Describe the use of Real Options Theory in Financial Management/Modeling in the field of adult development, identifying the main issues and specific current and/or future applications and relevance to the work place.

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This solution describes the use of Real Options Theory and identifies the main issues and current/future applications.

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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. Without real options, the company cannot alter their strategies for fear of discounting the original proposal.

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. 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 ...

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