Application Of Real Options Research Articles

What Is Not a Real Option: Considering Boundaries for the Application of Real Options to Business Strategy

What Is Not a Real Option: Considering Boundaries for the Application of Real Options to Business Strategy

The derivation of R&D return indicators within a real options framework

The purpose of this paper is to rework the building blocks of real option applications and to introduce a basket option framework. We find that the characteristic parameters of the risk neutral density function implied in observed share prices within the real option framework represent a novel category of R&D return indicators. Empirical evidence for a set of 13 US bio‐pharmaceutical companies is provided. The novel R&D return indicator can be used to analyse investor's expectations on R&D success of a particular firm. The implications of this indicator on decision making are mainly based on its information content on technological and market risk of the products under development in a particular firm. A proposal for a potential application of the stability index in innovation research is discussed as well. The study thus is at the interface between innovation research and (empirical) finance.

Optimal investment in an automatic milking system: an application of real options

Automatic milking systems (AMSs) are a relatively new technology characterized by uncertainty and irreversibility. The choice to invest in such a system is analyzed in a real options framework. Alternative financing arrangements, depreciation methods, and other factors are investigated to determine their influence on the optimal investment decision. The results suggest that farm capital structure, loan term, and depreciation method have little impact on the investment decision. The primary determinant in the AMS technology adoption decision appears to be whether the AMS will last longer than the existing parlor.

Making Decisions Under Uncertainty — Implications for High Technology Investments

Businesses are continuously confronted with decisions that have to be made under different degrees of uncertainty. The project investment strategy adopted by a company will have a major impact on its future growth and profitability. Managing a company is therefore primarily about managing uncertainties and understanding the relationships between the risk and the opportunities in each business proposal. This paper discusses the inadequacies of net present value (NPV) modelling in dealing with the management of uncertainties, which are common in ‘high-tech’ investments. NPV modelling deals with uncertainties by increasing the discount rate, which reduces the probability of approving the project. However, by including management options into the project valuation process the value of the project may increase substantially and therefore have an impact on the decision to go ahead or not. We discuss how the application of real options is superior to an NPV approach as it enables the investor to put concrete value on the project uncertainties. The key is flexibility in dealing with the uncertainties by having various options in place that can be exercised as new information emerges. The options derive their value from the fact that they put a floor under possible project losses. We apply the binomial tree method to the valuation of various options associated with high-tech investments, including the option to defer, expand or contract a project. We also consider the value associated with a mixture of equity and debt financing of high-tech, high-risk research projects.

A REAL OPTIONS DESIGN FOR PRODUCT OUTSOURCING

ABSTRACT Product outsourcing is recognized as a way to gain flexibility for competitive advantage. We formulate the outsourcing problem using real options. We develop a financial model to assess the option value of product outsourcing. Specifically, we consider a three state-variable problem and use Monte Carlo simulation to estimate the value of the option. This valuation gives decision makers a way to choose the appropriate outsourcing strategy based on an integrated view of the market dynamics. A case example from the apparel manufacturing industry is used to demonstrate the application of real options to value outsourcing flexibility. We show that the inability of classical net present value methods to address dynamics in the market condition leads to an undervaluing of the outsourcing strategy. Numerical results and sensitivity analysis show how the real options approach can be used to give a better view of the long-term value of outsourcing.

Real options analysis of the Minami Alps forest road construction project: new valuation approach to social infrastructure project with sequential unit projects

This article illustrates how the real options approach to public project evaluation is executed with a large-scale forest road construction project in one of the national park regions in Japan as a case study. Paying due attention to the existence of specified beneficiaries who want to make sure the allocated cost burden is warranted by prospective tangible economic benefits realized by the project’s execution, framing the real options application to public projects is made possible with the use of market-priced risk value in similar public projects. The article analyzes ex ante project evaluation models under both the existing legal framework and a new legal framework that allows the option to abandon the project totally or partially and clarifies how positive net present values of the Minami Alps forest road construction project depend on the cost-effectiveness parameter values of environmental damage mitigation activities and the degree of uncertainty embedded in the planned project. The article also executes sensitivity analysis to illustrate how the optimal domain of cost-effectiveness parameter values are affected by other parameters, such as the investment cost of unit project; and summarizes its contribution to the field of public project evaluation.

Dynamic capability view in terms of real options

In this paper we will make an attempt to open up the black box of the modern basic theory of strategic management, i.e. the resource-based view. We will launch a dynamized version about it and interpret its usability in terms of real options applications. According to the dynamic capability view of the firm, the company consists of human, physical and financial resources and its knowledge base, which, in turn, consists of already existing and routinely exploited, i.e. static and not yet fully developed or exploited dynamic capabilities, which both can be produced either internally by the firm itself or externally through the open market or networks. It is widely recognized that in modern firms especially the development, creation and management of dynamic capabilities is of utmost strategic importance. Our paper focuses on the hard issue of managing and valuating dynamic capabilities when designing the strategic boundaries of the firm, let us say when making decisions about network relations. To be able to do this, we will take a broad look at the real options approach as a special method to shed some light on the very aspects of coping with technological and market uncertainty. Some empirical industry-related illustrations about real options applications are launched as well.

Calibration of a basket option model applied to company valuation

Applying real options thinking to company valuation seems theoretically and intuitively appealing. However, the real option analogy of a single European option as well as the compound option proxy perform poorly when applied to company valuation. We therefore suggest to rework the building blocks of real option applications to corporate valuation.

A REAL OPTIONS DESIGN FOR QUALITY CONTROL CHARTS

We develop a financial model for a manufacturing process where quality can be affected by an assignable cause. We value the real options associated with applying a statistical process control chart using the Black-Scholes equation, binomial and pentanomial lattices, and Monte Carlo simulation methods. This valuation gives decision makers a way to choose the appropriate quality control strategy based on an integrated view of the market dynamics with the manufacturing operational aspects. An industry case is used to demonstrate the application of real options to value control chart decisions. Web based programs are given to value the alternatives in the case study, making the valuation task accessible to other users.

Valuing Technology Companies: Weaknesses of Traditional Accounting Methods and Strengths of Real Option Applications

Traditional accounting procedures, such as generally accepted accounting principles in the United States, do not adequately capture the valuation issues of companies. Wide-ranging suggestions have been made to allow current accounting practices to incorporate the New Economy characteristics of uncertainty and flexibility, and one of the possible remedies is to use real option analysis.

Real-Options Application: From Successes in Asset Valuation to Challenges for an Enterprisewide Approach

Real-Options Application: From Successes in Asset Valuation to Challenges for an Enterprisewide Approach

STRATEGY AND SHAREHOLDER VALUE CREATION: THE REAL OPTIONS FRONTIER

The current interest in real options reflects the dramatic increase in the uncertainty of the business environment. Viewed narrowly, the real options approach is the extension of financial option pricing models to the valuation of options on real (that is, nonfinancial) assets. More broadly, the real options approach is a way of thinking that helps managers formulate their strategic options—the future opportunities that are created by today's investments—while considering their likely effect on shareholder value.But if the real options framework promises to link strategy more closely to shareholder value creation, there are some major challenges on the frontier of application. In the first part of this paper, the authors tackle the question, “What is really new about real options, and how does the approach differ from other wellestablished ways to make strategic decisions under uncertainty?” This article provides a specific definition of real options that relies on the ability to track marketpriced risk. Using examples from oil exploration and pharmaceutical drug development, the authors also show how specific features of the industry and the application itself determine the usefulness of the real options approach.The second part of the paper addresses the question: Given the many differences between real and financial options, how should a real options application be framed? The authors examine the use of real options in the valuation of Internet companies to demonstrate the required judgment and tradeoffs in the framing of real options applications. The case of Webvan, an online grocer, is used to illustrate the inter‐action between strategy, execution, and valuation.

Challenges to the practical implementation of modeling and valuing real options

A great deal of theoretical work exists on how to model and value investment opportunities having real options. To date, this work has provided new insights into capital budgeting decision-making and a new decision-making framework. However, the currently proposed real option models are not widely used by corporate managers and practitioners. The question is, “Why not?” This paper posits one possible answer to that question. Specifically, this paper reviews what has been accomplished in modeling and valuing real options and examines practical implementation problems associated with the real option approach. The issues examined are: (1) The types of models currently used are not well known or understood by corporate managers and practitioners; (2) The required modeling assumptions are often violated in a practical real option application; and (3) The necessary additional assumptions required for mathematical tractability limit the scope of applicability. We then discuss possible alternatives for modeling and valuing real options that capture the essence of the problem, but do so in a simpler framework. This paper demonstrates the need to identify and develop alternative frameworks for practically modeling and valuing real options.

Multi-stage real options: The cases of information technology infrastructure and international bank expansion

This paper examines multi-stage real options applications that have strategic import beyond that captured by standard DCF valuation approaches. After reviewing the concept of multi-stage options in the case of RD and the international expansion option by a bank. It is shovm that options valuation can justify making such strategic investment decisions even if NPV suggests otherwise.

Case Studies on Real Options

This paper presents major insights gained from actual, practical cases of real option applications in cooperation with Shell group planning. The main interest of Shell was to conduct a number of exploratory studies on the use of option pricing theory in capital budgeting decisions. The studies were part of a group planning program to adapt existing and to develop new techniques for strategic decision-making.