Question

1. In your own words, describe what real options are in relation to capital budgeting. Describe two specific examples of real options. In general, how do real options tend to affect project NPVs and why? (10 pts.)

Answer 1

Real option is basically a right and not an obligation to take a decision in future. It is called real because it takes into consideration tangible assets rather than financial instruments. Examples of Real option are an option to expand, to abandon , to switch and so on. The option to abandon comes into play when a firm purchases an asset that it may later resell or put to an alternative use, should future conditions be sufficiently adverse. Availability of this option will increase a firm's propensity to invest relative to simple Npv rule which omits future divestment.

In general real option increases the Npv of the project, due to the presence of option. The value of the real option increases the amount of project NPV . This is because, earlier the project only had its cash flows to be taken into consideration, but now it also needs to take into consideration the value of option , which creates an economic value.

Presence of real option provides an option to take a project in future, rather than choosing the project now or never as done in the case of Npv.