Uncertainty, risk, and real options: who wins, who loses?

Abstract

PurposeReal‐options have moved from being an academic theory to a decision‐making tool that is being used by managers. The thinking underpinning real options has remained true to its financial options‐pricing heritage, which means that it is based on an assumption of managerial risk‐neutrality. Managers can be risk‐seeking or risk‐averse, depending on whether or not they are meeting performance targets. This paper aims to explore the questions of what happens when the assumption of risk neutrality is relaxed and how the outcomes of managerial decisions on investments affect the firm's stockholders and bondholders.Design/methodology/approachThe work is conceptual in its approach.FindingsManagers, stockholders, or bondholders do not lose when managers are performing above target and when environmental uncertainty is high, or below target when environmental uncertainty is low, but managers win at the expense of stockholders when they are meeting performance targets and uncertainty is low, and managers win at the expense of bondholders when they are performing below target and uncertainty is high.Research limitations/implicationsPropositions are provided for subsequent empirical testing. The paper holds environmental complexity and munificence constant, but discusses the implication of that in the conclusions.Practical implicationsThe research has implications for shareholders and bondholders. It also has implications for Boards of Directors and the actions they take within their monitoring and control duties.Originality/valueBecause the paper is able to separate the constructs of uncertainty and risk, this is the first work that has been able to fully relax the assumption of risk neutrality that underpins real‐options theory.