Question

Describe the Real Options approach towards investment appraisal, and suggest the circumstances when this type of approach can be beneficial.

Answer 1

Real Options approach towards investment appraisal

Real option approach helps in investment decision making when the future is uncertain. In this approach, there is an assumption that company has choice of when to invest in particular project similar to an option. Net present value method assumes that investment is to be made now or never whereas real options approach recognises that managers have choice as when and what actions to undertake. This approach calculates the value for the flexibility and choice which is present while making investment appraisal. It views risks and uncertainties as opportunities.

It considers the ability to invest now and follow up investments later in case of success. It values the ability to abandon the project and also to wait till uncertainty exists. It helps in investment appraisal as it shows series of options that can be exercised to gain short and long term returns on investments.

Circumstances when this type of approach can be beneficial

1. Valuation of High Tech companies

2. Development of natural oil fields

3. Valuations of mergers, acquisitions and joint ventures