Question

Explain why real options have the potential to be an important tool for firms in strategic and financial analysis.

Answer 1

Real options have the potential to be an important tool for firms in strategic and financial analysis because :

• real options are important in strategic and financial analysis because traditional valuation tools such as npv ignore the value of flexibility. It is essential to consider real option evaluating a company's stock price because they indicate the future potential of a company where book value and DCF analysis fail to display.
• On other hand, pay back method of analysis ask how many periods management must wait before cumulated cash flows of a project exceed the cost of investment. But it doesn't consider the further cash flows whether they are positive cash flows or negative. So payback method of analysis doesn't give true picture. Where as real options analysis considers both uncertainty and flexibility that generates their value.
• Real options provide a useful framework for strategic decision making. Real options analysis analises an investment which has irreversible cost in an uncertain environment.
• Real options can also value the ability to abandon the project if it is unsuccessful.
• Real options can value the ability to wait and learn, resolving uncertainty, before investing.
• Real options focus on dynamic complexity; the evolution of a few complex factors over time that determine the value of investment and cash flows.
• Real options can distil your strategy thinking into focussing on a few, key dynamic processes.
• Valuing irreversible investment opportunities under uncertainty using npv doesn't take account of managerial options and treats capital assets as passively held. A real options approach can help by valuing these managerial intangibles and preventing mistakes.