Real Options Approach Research Articles

A real options approach to decision making in broadband technology selection

The European Union has recently launched an ambitious plan to mitigate drastically, by 2025, the number of households lacking access to a 100 Mbps broadband connection through the subsidisation of the deployment of network infrastructure in rural areas. Decision makers such as governments and regulatory authorities therefore have to choose, among a pool of alternatives, a technology capable of delivering the required throughput on a large scale, based on a trade-off between the infrastructure costs and the subscribers' perceived utility for each alternative. Such a trade-off is not simple, since there is no straightforward manner to rank the subscribers' perceived utility against the network infrastructure cost. In this article, we propose a methodology based on real options, which outputs the value of each technology using multi-attribute value theory as an input, alongside the project's risk and its costs.

Метод реальных опционов в оценке стоимости месторождений

Income approach based on the method of discounted cash flows (DCF) seems to be the main instrument to evaluate economic efficiency of investment projects when developing oil and gas fields. However, at early stages of exploration and exploitation of hydrocarbon resources, uncertainty and risks of investors are very high, which limits the use of traditional methods. It is necessary to develop valuation tools accounting high uncertainty of input data on the exploitation of oil and natural gas resources, flexibility of their development by formation of rational production strategy with volatility of the operating parameters such as the world oil prices and the size and value of oil and gas reserves. In this article presents the real options approach which accounts the potential of flexible and adaptive project management providing advantages in assessing development projects as compared to the traditional income methods. Implementation of this method is exemplified by the case of oil and gas fields in the east of the Siberian platform.

Investment Decision Making under Uncertainty Using Real Options Approach: A Case Study in Solar Power Plants of Iran

Investment Decision Making under Uncertainty Using Real Options Approach: A Case Study in Solar Power Plants of Iran

Towards improved port capacity investment decisions under uncertainty: a real options approach

ABSTRACTPort activity plays an important role in facilitating international trade. Sufficient capacity is indispensable for a port to attract flows to a region and retain them. The capacity decision is the result of a trade-off between investment and waiting costs. Traditional methods to value expansion projects do not deal adequately with managerial flexibility in the face of uncertainty from different sources in the complex port environment. In this paper, real options (RO) models are identified as an alternative method to making project valuations and investment decisions, as they attribute the correct value to managerial flexibility under uncertainty. In order to be able to build and use such RO models for port capacity investment decisions, the sources and implications of uncertainty in the port and the different RO model specifications need to be understood. To this end, both the literature about uncertainty in the port context and the literature about real options models are reviewed in order to provide researchers who want to build their own decision-making models, with the necessary knowledge of both fields. The review makes clear that the complex interactions in and competition between the logistics chains and their actors coming together in ports have significant impacts on port capacity. Uncertainty is also caused by uncertain international trade flows and changes in legislation following new technologies and environmental impacts. An analysis of the components of some general RO models shows how the options of flexible output, investment size and timing are valued by RO models in a setting with demand uncertainty. Moreover, the review presents researchers with insights in how to deal with cooperative and competitive interactions in the chain, time to build, cyclical markets and legislation changes. It also shows how to value the expansion and the phased investment options. The new insights resulting from this review are subsequently combined in a framework that serves as a guideline to build RO models for port capacity investments. Finally, an exemplifying application of the framework is used to build an actual port capacity investment decision model.

A Review of Carbon Capture and Storage Project Investment and Operational Decision-Making Based on Bibliometrics

The research on carbon capture and storage (CCS) project planning and investment and operational decision-making can provide a reference for enterprises to invest in CCS and for policy-makers to formulate policies to promote CCS development. So what are the current research hotspots in this field and the gaps that still need to be further studied in the future? This paper reviews the research in the field by a bibliometric analysis. The results show that the research in this field first focus on cost analysis, followed by project investment evaluation, project planning (cost curve and pipeline network), and project operation. In particular, fossil fuel power plants, pipeline transportation, and oil fields are the most crucial objects in the three technical links of CCS projects, respectively. Policies, carbon pricing, and uncertainty in cost and benefits are factors that are mainly discussed in this field. The methods used for CCS project planning are cost curve model and optimization model. The real option approach is suitable for the evaluation of investment decision-making. The evaluation of operational decision is mostly based on optimization model. The future research directions can be summarized as five points: (1) continuously and systematically update the calculated costs in the current research to the unified price of the latest year; (2) calculate the cost curve from the perspective of emission sources; (3) expand the planning region of pipeline network to the country, continent, and even the entire world; (4) pay more attention to the investment assessment of the CCS project that may be implemented with low cost and high return; and (5) analyze the optimal operation mode of CCS in the low-load power system.

Public Funding for Science and the Value of Corporate R&D Projects; Evidence from Project Initiation and Termination Decisions in Cell Therapy

AbstractHow do firms decide which R&D projects to pursue and which ones to cast aside? We use a real options approach to advance our understanding of how firms manage uncertainties in R&D project management, in particular uncertainties linked to the external scientific environment. Our findings highlight how these uncertainties have an impact on the initiation and discontinuation of R&D projects. We examine these effects in the context of shifts in US science policy in the cell therapy field, using a dataset on 570 R&D projects in the global cell therapy sector, initiated over the period 1986–2011. We find decreased R&D project initiation rates and higher discontinuation rates for projects initiated by US firms in the aftermath of policy shifts that increased uncertainties about public funding support for US cell therapy research. We also highlight how this effect was reversed as the US public funding outlook for such research recovered.

Sustainable Value of Investment in Real Estate: Real Options Approach

The issue of application of real option valuation approach in the valuation of investment project is presented in the article in a way in which the flexibility of the project could be included in the process of its valuation. The authors apply the valuation approach in case of a specific investment project in the real estate in the capital city of the Czech Republic—Prague, using the option to expand, to contract, and to abandon the project. The main aim of this case study is to present a practical application of the investment valuation and to construct an option pricing model for real estate investment which considers and integrates as many aspects of the investment and market environment as possible to describe the best situation of the real estate market and its development. The valuation of the investment is carried out using a universally applicable numerical method of binomial trees. The results obtained are subjected to the sensitivity analysis with respect to the discount rate, value of the most influential parameter of the volatility and the input option parameters. The results of the valuation of the project obtained using the real option approach are important mainly for the management of the company in the process of quantification of the present value of future investments. Implementation of managerial interventions enables for optimizing the value of the project not only in case of favourable development of the real estate market, but particularly in case of unfavourable development. Therefore, they are important in order to protect an investor from potential high losses. Finally, the valuation of these interventions increases the present value of the project, contributing to the decision of the corporate management regarding its implementation.

Optimal Investment Timing and Scale Choice of Overseas Oil Projects: A Real Option Approach

This article presents a real option model for helping investors to determine the optimal investment timing and scale of overseas oil projects. The model is suitable for the highly uncertain environments in which many oil companies operate, where they have to suspend upstream investment, stop new oilfield construction, and wait for proper oil prices in order to avoid losses. Considering the uncertainty of oil prices and exchange rates, the results of analytical solutions presented in this paper show the critical oil price that can be seen as the investment threshold for triggering oilfield development as well as the optimal recoverable factor for every oil price level to indicate the optimal investment scale. Results of the case project show the critical oil price, which is 82.32 US dollar per barrel, and the selection of optimal investment scale. The article also demonstrates the impact of investment scale on investment timing in overseas oil projects. The policy implication from the case project is that investment decisions are finitely impacted by geological conditions. Besides, the existence of tax holiday directly contributes to a lower investment threshold. In addition, reducing unit operation cost can obviously enlarge optimal investment scale and initiate oil projects in a relatively low level of investment threshold.

How time-inconsistent preferences affect investment timing for rail transit

We address optimal rail transit investment issues considering time-inconsistent preferences and population uncertainty. Instead of adopting the typical real options approach which assumes that authorities possess a constant discount rate over time, we propose an extension of real options analysis by modeling authorities’ intertemporal choices with a quasi-hyperbolic discount function. Depending on the assumption about the strategies guiding the behaviors of future authorities, we consider three types of authorities, namely time-consistent authority, naïve authority and sophisticated authority, of which the latter two are time-inconsistent. First, an optimal transit investment timing model is proposed. Then, solutions for the above three types of authorities are derived and compared. We demonstrate the performance of the proposed model by conducting numerical tests and applying it to Dalian, China. Main findings include: (1) an authority with time-inconsistent preferences makes decisions earlier than a standard, time-consistent authority; (2) the sophisticated authority invests earlier than the naïve authority. Other implications of considering time-inconsistent preferences are also identified.

Market driven ship investment decision using the real option approach

This paper analyzes ship investment behavior where the main driving force is future freight earnings. The shipping market is cyclic and uncertain, and the decision is whether to invest ships now or later. Theoretically, we found the trigger rates—the necessary freight rates for profitable ship investment—for both the net present value (NPV) and real option approach (ROA), assuming that future freight earnings follow a mean reverting stochastic process. The combination of these trigger rates provides the necessary and sufficient conditions for immediate investment. Empirically, we estimated the trigger rates for the whole sample from January 1976 to July 2014, as well as sub-samples that take into account structural changes in the shipping market. Both theoretical and empirical results show that ship investment decisions can be made based on the relationships between the current freight rate and the trigger rates from NPV and ROA. If the freight rate cannot make NPV positive, no investment should be considered. Immediate investment is only recommended when the freight rate is higher than the trigger rate using ROA. Sensitivity analysis shows that the trigger rate is most sensitive to changes in the long-run mean of the freight rate. A simple regression analysis indicates that our model can explain market driven ship investment activities in the past. In addition, results that incorporate structural breaks in the shipping market are closer to actual investment behavior in the market.

The Impact of Aligning the Strategies of CREM with Those of a Corporate Business Using Real Options

The article investigates the benefits of incorporating corporate real estate management (CREM) in the main business units of the company. Prior studies have illustrated that CREM unit in major companies is treated as a separately entity with less focus on its contribution to maximization of shareholders’ wealth. This article uses real option approach, specifically Samuelson-McKean (1965) model to extrapolate the value of CREM of listed South African insurance company. The results show that when CREM is insourced and treated as a significant part of the main insurance, shareholders’ wealth is maximised-value of the company increases, total costs are managed and financial parameters increase investment value-volatility can be as high as 100%. Although, the data is on financial services, the results can be replicated in other industries given that the analysed company has exposure to a number of industries.

Passive farming and land development: A real options approach

The EU's farmers are no longer required to produce commodities to receive direct payments as long as they keep their land in good condition. Some believe this is bad for development because it encourages passive farming. We evaluate, using a real options approach, the implications of decoupled payments for the desirability and optimal timing of agricultural land development when considering sunk investment costs and uncertain future returns. We find that decoupled payments accelerate development while passive farming increases, by adding managerial flexibility, the value associated with land. We then use the Nash bargaining solution to identify the rental share to be paid for leasing land. We show that a deal for the lease of land can always be reached, but that the facility to use passive farming as an outside option allows landowners to extract policy rents, thereby undermining the potential for the Basic Payment Scheme to support tenant farmers’ incomes.

Minimum revenue guarantees valuation in PPP projects under a mean reverting process

Minimum revenue guarantees, where the government assumes a portion of the traffic risk to guarantee a minimum level of revenue and profitability to the investors, is a standard risk mitigation mechanism for Public-Private Partnership contracts. Typically, valuation models for these guarantees assume that traffic volume follows a geometric Brownian motion under the Real Options Approach. However, this is often done without testing whether this assumption is reasonable or not. In this article, statistical tests are applied to check the validity of this assumption and show how toll road traffic can be modelled under alternate models, such as Mean Reverting processes, if the geometric Brownian motion assumption is rejected. In that sense, this approach is applied to the case of a toll road concession in Colombia where a Mean Reverting process is used to model the traffic. Finally, it is showed that this model is a valid tool for defining the fair value of the minimum amount of revenue secured by the government.

Valuations and Decisions of Investing in Corporate Social Responsibility: A Real Options Viewpoint

Corporate social responsibility (CSR) implementation could raise corporate reputations and benefit long-term development. Studying the effects of CRS on corporate valuation is essential. However, studies on the valuation of CSR are limited, particularly studies involving a dynamic model for valuing CSR. This study applies a real options approach to derive the company valuation of CSR investments, CSR options value, and the optimal timing for implementing CSR. This study elucidates the value of CSR and the decision to invest in CSR. Specifically, the value of CSR options facilitates determining whether to invest in CSR, and the optimal threshold for implementing CSR indicates explicitly when to invest in CSR. In addition, numerical analyses and results are demonstrated to verify the established model. This is the first and novel attempt to consider the valuation model and optimal strategies of CSR investments using the methods of real options.

A Real Options Model for Analysis of Industrial R&D Expenditures

The objective of this paper is to develop the model that can be used to explain the amount of research and development (R&D) expenditures of large and mature companies. The research methodology is based on real options approach. We model companies’ R&D expenditures as payments for the real option, which is the right of a company to invest in real assets in the future, and therefore to ensure business development. The main result is a valuation model, which includes several relevant factors. While existing research papers apply real options approach mostly to the R&D projects of particular companies or within particular industries and situations, the current paper applies the corresponding methodology in general and aggregated setting. We hope that it will contribute to understanding of R&D intensity in large innovative companies.

A real-option approach to mitigate disruption risk in the supply chain

We study the optimal ordering decision policy for a retailer who is exposed to supply disruptions along with correlated demand and price uncertainty. A new modeling approach to optimize inventory planning in a two-stage supply chain is proposed in order to choose an optimal order quantity that maximizes the expected terminal profit. With the aid of real-option pricing methodology, we derive an explicit form of the profit function and adopt a dual sourcing strategy that allows for disruption risk mitigation. Then we drive a solution to the given problem, facilitated by the use of an actuarial technique. This study reveals that when demand and price are assumed to be stochastic, the objective function features four terms that resemble the pay-off of real-options, corresponding to risks of shortage and write-off. Therefore, the optimization problem can be reduced to determining the fair value of those options. The model is contextualized using an example from the Chinese dairy market. Sensitivity experiments are performed to demonstrate the robustness of the developed approach. The results can be used by managers to decide on ordering quantities at the beginning of each period, which maximizes the expected profit, while also considering the disruption risk of the primary supplier and correlated demand and price uncertainty.

Valuation of CCS investment in China's coal‐fired power plants based on a compound real options model

AbstractA two‐stage compound real options model is proposed to evaluate carbon capture and storage (CCS) investment decision making from the perspective of coal‐fired power plants, considering the phased nature of CCS technology. A newly built coal‐fired power plant is used as a case study for the application of the compound real options model. The results indicate that the compound real options approach has an advantage over both the traditional net present value (NPV) and single‐option method when handling multistage investments. Although the present carbon price level is not high enough to encourage CCS investment, the critical carbon price will decrease when considering the upside potential inherent in the CCS investment. Further analyses indicate that the timing of the second phase of a CCS project and other factors will also affect the critical carbon price and the value of a CCS investment. These findings will be useful for decision making associated with CCS investment, and related policy making in an uncertain environment. © 2018 Society of Chemical Industry and John Wiley & Sons, Ltd.

A real option approach for the valuation of switching output flexibility in residential property investment

PurposeUncertainties in residential property investment performance require that real estate assets are designed in a flexible manner to respond to impacts of market dynamics. Though estimating the cost of flexibility is straightforward, assessing the economic value of flexibility is not. The purpose of this study is to explore the potential practical application of real option analysis to determine the economic value of a switching output flexibility embedded in a residential property investment in Australia. The study involves the exploration of an optimal strategy for investment in a residential development through real option analysis and valuation of a mixed use investment.Design/methodology/approachThe real option valuation model developed by McDonald and Siegel (1986) is adopted for the evaluation because the switching output flexibility is likened to a perpetual American call option with dividend payout.FindingsThrough real option analysis, the economic value of switching output flexibility of the mixed use building was determined to be higher than the initial upfront costs. Moreover, a payoff of about $4million was determined to be the value of the switching output flexibility, therefore justifying upfront investments in flexibility as an uncertainty and risk management tool.Practical implicationsThis application is an important demonstration of the practical use of options pricing techniques (real options analysis) and delivers further evidence needed to support the adoption of real option valuation in practice. Flexibility can also enhance risks and uncertainty management in residential property investment better than the adjustment of discount rates.Originality/valueThere is limited evidence on the use of real options techniques for the valuation of switching output flexibility in practice, and this comes as an original application; both the case study and data are all initial applications of switching flexibility in the Australian property market.

Creating comprehensive leadership pipelines: Applying the real options approach to organizational leadership development

Typically, firms consider leadership development (i.e., training focused on skills required for success in leadership roles) and succession planning (i.e., the creation and implementation of long-term plans that address changes in top leadership roles) as two distinct organizational initiatives. In recent years, however, scholars and practitioners have called for a new, more comprehensive approach that considers the organization as a system. Rather than considering succession planning and leadership development as distinctly different initiatives, organizations should work to create internal leadership pipelines that span entry-level employees to executives. To leverage potential advantages associated with instituting comprehensive leadership pipelines and to address practical concerns associated with risk and talent management, we propose the introduction of incremental investment in organization-wide leadership development programs via distinct, evaluative stages – a real options reasoning (ROR) approach to leadership. We argue that blending ROR with skills-based leadership models diversifies risk associated with investments in talent management and increases the ability for targeted, purposeful investment in potential organizational leaders.

Valuation of innovation projects with high uncertainty: Reasons behind the search for real options

Abstract Real Options (RO) has been indicated to valuate projects with high uncertainty. However, literature points to challenges and asks for an organizational understanding of its use. So: Why do managers search for the RO approach to valuate radical innovation projects? Based on five in-depth case studies, we discuss hidden organizational and managerial issues related to the search for RO to valuate radical innovation. We argue that managers search for RO to cope with the “paradox of organizational fit”, and later, to deal with the “newness prison”, employing RO Structuring and RO Integration to allow exposure to radical innovation.