Question

Give an example in business for each of the following real options with clear explanations. If you manage to put some numbers in your examples and sketch how you may value such optionality the better but not required. The option to expand if the immediate investment project succeeds. The option to wait (and learn) before investing. The option to shrink or abandon a project.

Answer 1

The option to expand if the immediate investment project succeeds

Consider a scenario , where a business in the steel industry has invested in a project for optimizing the production of its raw steel sheets i.e. the technology would increase the number of sheets while at the same cost. Since the number of sheets produced would increse, and the factory might not be able to cater to the newly increased quantity of goods, hence the firm should expand.

The option to wait (and learn) before investing

Consider a FMCG firm. It is planning to acquire a new vertical, say that of shampoo. Now they see that there are two possible choices for businesses to invest in. One that is used on a large scale by the public and another which is more differentiated and used by premium customers. Hence before investing in this scenario the firm must evaluate various scenarios, must wait and see how both the businesses perform to various economic cycles and then invest.

The option to shrink or abandon a project

Consider a scenario where a scenario where a tobacco firm invests in a new project to build a factory in a local municipality. The government and regulations were supportive at the time of building the project and the location was also very strategic. But after the elections, the new government doesn't seem supportive of the factory and places export expenditures. Also, the nearby people have started to abandon the product and the importing countries would levy import tariffs. Hence in this scenario, the best decision would be to abandon or shrink the project.