Question

What are real options? Identify the tools and techniques available for managers for analyzing the profitability of the project. Discuss how the identified criteria are used in selecting profitable capital projects.

Answer 1

Real options refer to the choice made available to the management of a company regarding business investment opportunities. It is termed as real because it typically involves tangible assets rather than financial instruments. Tangible assets are those assets that can be seen or feel such as machinery, inventory, land and buildings.

The most preferable technique that is used to analyze the profitability of the project is NPV method under which present value of cash flows is computed and a project is accepted when its NPV is positive or greater than 0. But in case both mutually exclusive projects have positive NPV then project with the higher NPV is selected.

Present value of cash flows is computed using a discount rate.

Other methods of analyzing the profitability of the project are as follows-

IRR ( When IRR is greater than the cost of capital project is selected)

Payback period (Project with less payback period is selected)

Profitability index. (Project having Profitability index greater than 1 is selected)