Question

What value does Real Options analysis add to capital investment decisions? In what cases would there be value in using this technique?

Answer 1

The real option analysis (ROA) is used to take capital investment decisions when companies are investing in risky assets. It is generally used for analysis of the projects investing in tangible assets instead of financial instruments and uncertainties are very high. The decisions are taken based on the observations of real worlds happening and accordingly the companies decide that expand the business or curtail them as per the situations arise. Real option is the right available to the company to take the business decisions in its best interest, it is not an obligation.   

In the real options analysis, company used updated knowledge or information to expand opportunities and reduce the risk. There are three different options that can be utilized to take best investment decisions.

• The option to expand: If the business prospects are good in coming future in that case they can plan to expand the business to increase its possible profits.
• Option to curtail the Investment: If the business prospects are not seems good in near future, curtailing the investment is good option to reduce the possible losses.
• Option to Wait or Delay the investments: If the information available is not giving any clear direction for the future prospects it’s better to use the option of wait and watch and delay the investments for some time. By this way companies take more time for the investments decisions in the future so that uncertainties can reduce in near future and they can take more confident decision.