Question

What is a real option? Why are real options important in financial decisions?

Answer 1

Ans. Real option is not the option which is there in derivatives but the defination is similar, it is the right but not obligation for a business to make a decision. In fact it is the actual advantage or benifit the business may take from the decisions they make. For example investing in a project, buying fix assets to name few, getting into a new product.

These options are taken keeping in mind the capital structure of the company. The management consider the impact of these decision on the financials.

The type of options are:

1. Option to expand: It is the option to expand the business or undertake a project in the future to expand the operation.

2 Option to abondon: It is the option to leave any project or sell off any business

3. Option to swtich: It is the otion to shut down the project at the time it is not favourable, and then resume it later on at the time it is favourable.

The real option can be pricesd based on the NPV method. For example the option to expand the business, the future cashflows need to be calculated, and then the cost is determined. The present value of the cashlow is calculated taking the growth rate and the discounting factor. And then the NPV is calculated. Although in real scenario it gets very difficult to determine the vlaues.

The value can also be determined based on the decisions tree, and can also use monte carolo. All needed is the probabilities, and the cashflow from the projects.

The real option has big impact on the financial decisons of the company. As mentioned these are the real decisions which the company makes, as a result it has a direct impact on the profitability of the company.

Based on the types of real options it is visible what kind of impact the particulare decision will have.

If a company plans to invest (decision to expand) the comapny will need a lot of cash, and it will flow outside. So, the debt may incrase, the assets will increase, the profit will take a hit as the interest will also increase. The majority of the portion for intital years will be going towards the project or the investements. But later on there will be an expansion and the sales will increase and return will start to flow in for the investements which were done.

A company will keep a lot of the factors which are financial in nature before making a decision in real life. The finance is the element which will impact the decision a lot. The financial strength will enable the company to make the decision. The decisions in real options are measured based on cost or the profit made, so that is why the finacnial decisions are very important in these type of situations. Unlike financial options the loses are not restrictive, it can have a chain affect where one bad decision can lead to a company getting bankcrupt.