Real optionsPrepared bySubmitted to Word count1758 words (excluding content and reference pages)IntroductionThe real options valuation is termed as an improved decision making that goes into the project. This is not widely accepted in the recent past, because many project managers worried about the expensive software usage due to the esoteric black scholes equations frequently used. This, in view of them needs a specialist finance expert in the project team. The managers who are familiar with this valuation will use decision tree frame work that best suited to contingencies. This decision tree framework can be used as strategic planning tool and decision analysis.
The adoption of real options method is due to the problems that can be posed by NPV. This is because the NPV assumes conditions of low uncertainty. The uncertainty is not enough to contemplate changes in the strategic plan. In net present value, the opportunities are estimated only on the basis of current information and not future analysis is taken into consideration. Generally most of the businesses cannot decide on now or never variety. They plan strategies on the magnitude of uncertainty.
The uncertainty also can be taken into consideration while planning strategies. Real option valuation can enable the managers to estimate and react to the risk simultaneously. This can be efficiently used in constant price shifts, fluctuating interest rates and fickle customer tastes due to emerging technologies. Keeping the above situations in view, the Real options valuation can play an important role in developing a strategy. This strategy can guide the managers and the company through the decision making process. Advantages of Real Options AnalysisThe advantages of real options can be termed as those more than the discounted cash flow analysis.
In DCF analysis the project’s cash flows are assumed as that are in the onset. This may result in static approach in decision making regarding investments. It needs to be or assumes that all operations are made in advance. In case of real options analysis, the set of available investment projects are taken in order to decide those worth undertaking. The future cash flows can be expected and can be planned to be adjusted at risk adjusted to cost of the capital.
This option in real options valuation can help in minimizing the risk regarding cash flows in future. This can prove as an advantage when any company is trying to acquire a property on call option basis or introducing a new product with a breakeven period of 5 to 10 years. In case of acquiring a property, the future value of it can be estimated and utilizing the call option can be analyzed. In case of introducing a new product like napoleon company, the expectations of profits in the future years can be estimated in this context the real options valuation will be useful to take decisions of investments, cost and profit analysis about the future.
The real option valuation cannot be termed as a derivative instrument. The advantage of the option is that it is tangible in the sense of choice. The choice is due to the gains that can be made by the business by some endeavors. When a company like napoleon invests in a project, the real option of expanding, selling, downsizing or abandoning the projects and other ones can be estimated and the decisions can be taken according to the flexible budge proposals and even by minimizing the risks.