Real Options Theory

Abstract

Real options theory analyzes the value of managerial flexibility to adapt and revise future decisions to capitalize on favorable future investment opportunities or to limit downside losses from adverse market developments, which is vital to long-term corporate success in an uncertain and changing marketplace. Managerial flexibility manifests in terms of a set of corporate real options on whether to defer or stage investment, expand or grow, contract, abandon and switch use, or otherwise alter a capital commitment. Real options theory brings the theory of financial options from the capital markets to the realm of corporate investment decisions and strategic decision making under conditions of uncertainty. Real options are seen as opportunities (without an obligation) to acquire (dispose or reposition) real assets on possibly favorable terms. These terms depend on adjustment (or switching) costs, imperfect competition or other imperfections in product or factor markets. But whereas in the case of financial options the investor has the right to acquire (or sell) a financial asset (e.g., shares of stock) as the underlying security, in real options the underlying is a “real” asset whose expected future cash flows are linked to new product development via investing in an R&D program or the exploitation of a patent, the construction and subsequent scale up of a manufacturing plant in the home country, new foreign market entry and the growth or shifting of foreign subsidiary operations within the network of a multinational company (MNC), and so forth. Real options theory has thus extended options thinking (and methods) from the financial markets, where options are based on tradable contracts with specified terms, to real assets, tangible or intangible. Tangible or physical real assets underlying real options might include R&D and patents; land or real estate; natural resources, such as oil, gas, or mineral reserves; manufacturing plants; and strategic acquisitions; intangibles include brand and reputation, unique business processes, flexible human capital, and knowledge developed in joint ventures or other cooperative agreements.