Question

Real options always make a project more valuable.

Answer 1

Defination of Real options :

Real options are the right, but not the obligation, to acquire, expand, contract, abandon or switch some or all of an economic asset on fixed terms on or before the time the opportunity ceases to be available.

Pricing of real options :

There are various methods to evaluate the pricing of real options but NPV method is considered the most straightforward approach to value the real options. For example, for an option to expand the business operation, we can forecast the future cash flows of this project and discount them to the present value at the opportunity cost. We will use the option if the NPV is positive and dismiss it if the NPV is negative. However, in a real-life setting, the NPV approach can be hard to perform correctly.

Although there is much similarity between the modelling of real options and financial options, but the real option valuations also takes into account uncertainty about the future evolution of the parameters that determine the value of the project, including management ability to respond to the evolution of these parameters. It is the combined effect of these that makes real options valuations technically more challenging than its alternatives.

First, you must figure out the full range of possible values for the underlying asset. This involves estimating what the asset's value would be if it existed today and forecasting to see the full set of possible future values calculations provide you with numbers for all the possible future values of the option at the various points where a decision is needed on whether to continue with the project.

Therefore, the precise value of real options can be difficult to establish or estimate due to the key difference between real options and derivative contracts is that the derivatives contracts trades on the exchanges and has a numerical value while real options are subjective (decision to expand, defer, wait, or abandon the project) but by using the experience and financial valuations model, the management get some sense of the value of the project being considered and whether it's worth the risk.