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In many investment projects the firm faces one or more options to make strategic changes during its lifetime. A classical example is mining firm's option to suspend extraction of natural resources if the price falls below the extraction costs. Such strategic options are known as real options, and, can significantly increase the value of a project by eliminating unfavorable outcomes.
Generally there exist four types of "real options":
1. The opportunity to expand and make follow-up investments
2. The opportunity to "wait" and invest later
3. The opportunity to shrink or abandon a project
4. The opportunity to vary the mix of the firm's output or production methods
The option to expand is often imbedded in investment projects. The value of follow-on investments can be significant and in some case even trigger the project to have positive NPV.
Examples of options to expand:
- Provide extra land and space for a second production line when designing a production facility.
- A pharmaceutical company acquiring a patent that gives the right, but not the obligation to market a new drug.
- Building 6-lane bridges when building a 4-lane highway.
An investment opportunity with positive NPV does not mean that we should go ahead today. In particular if we can delay the investment decision we have an option to wait. The optimal timing is a trade-off between cash flows today and cash flows in the future.
Examples of timing options:
- The decision when to harvest a forest
Traditional capital budgeting assumes that a project will operate in each year during its lifetime. However, in reality firms may have the option to cease a project during its life. An option to abandon a project is valuable: If bad news arrives you will exercise the option to abandon the project if the value recovered from the project's assets is greater than the present value of continuing the project. Abandonment options can usually be evaluated using the binominal method.
Examples of abandonment options:
- Airlines routinely close routes where the demand is insufficient to make the connection profitable.
- Natural resource companies
Flexible production option
Firms often have an option to vary inputs to the production or change the output from production. Such options are known as flexible production options. Flexible production options are in particular valuable within industries where the lead time (time between an order and delivery) can extend for years.
Examples of flexible production options:
- In agriculture, a beef producer will value the option to switch between various feed sources to use the cheapest alternative.
- Airlines and shipping lines can switch capacity from one route to another.
Practical problems in valuing real options
Option pricing models can help to value the real options in capital investment decisions, but when we price options we rely on the trick, where we construct an option equivalent of the underlying asset and a bank loan. Real options are often complex and have lack of a formal structure, which makes it difficult to estimate cash flows. In addition, competitors might have real options as well that needs to be taken into account when the economic rent of the project is assessed.