8. Real options Projects are also often embedded with different options that can
ID: 2612239 • Letter: 8
Question
8. Real options Projects are also often embedded with different options that can help making decisions under uncertainty. There are techniques used to evaluate these embedded options which are called real options. The models used to value these options are based on the type of the real option available for the project Real options the value of capital investment projects. The managers of American Sporting Goods Inc. have induded an output flexibility option into the design of a proposed capital investment project I. This option allows the outputs of the production process to be altered if market conditions change during a project's life. II. This option provides a firm with the flexibility to increase the capacity of an existing product line, to add new products, or to expand into new geographic markets. III. This option allows a firm to postpone a project until it can gather more information or market conditions change. 1 ·This option allows a firm to temporarily terminate operations in order to prevent experiencing negative cash flows. Which of the listed statements best describes an output flexibility option? O Statement I O Statement II O Statement III Statement None of the statements listed above describes an output flexibility option O Real option analysis adds value to a project when it is used for which of the folowing? Check all that apply Modifying the way that decision makers perceive flexibiityin Captal budgeting activities Expanding the way that managers view nak and unartaney, seeing them asphenomena to bo appreciated and exploited rather than feared and avoided Making managers aware of the consequences of ther desons end eware of the consequences of their decisions and actions on the creation or destruction of actors on the out on or value for a capital project
Explanation / Answer
Real option is a choice available with a business investment opportunity. A real option is a right but not the obligation to undertake certain business initiative like deferring the project, abandoning the project, making an expansion, staging of production, changing the mix of products produced, reducing the a planned capital investment.
Normally a capital investment decision is taken forward if the Net Present Value of the Capital Investment , ie., net present value of the estimated cash flows of the project at a desired rate of return is positive. Alternatively, one can even arrive at the Project's internal rate of return (IRR) based on the estimated cash flows of the captial investment decision. If the IRR is equal to or more than the firm's required rate of return, the decision is taken forward. However the NPV may not be able to distinguish the alternatives available once the project implementation has started like completing the project as scheduled or delaying, reducing the output, changing the product mix, staging of production etc. These alternatives are taken into account in Real Option analysis and the NPV of flows of various options are estimated. Based on the values of NPV of the cash flows, a decision is taken to implement any of the alternatives available. However it is only a right available to the decision maker and not an obligation to implement the same.
Thus it can be stated that the real options can be used to estimate the value of various alternatives available and enhace the value of capital investment projects.
An output flexibility option allows a firm to change the product mix. That is to say the it is a right available to the managers to increase the output of a product line, reduce outputs of another product line thus changing the product mix produced by the firm depending on the external market situations and the benfits available based on changing the output mix.
Based on the above, Statement I viz., this option allows the outputs of the production process to be altered if market conditions change during a project's life best describes an output flexibility option.
Real Option Analysis adds the value to a project
Modifying the way that decision makers perceive flexibility in capital budgeting activities
- Real option analysis allows the decision makers aware of the various options available for implementation of a project like implementation, abadoning, postponement, changing the input mix, changing the output mix, expansion, reduction etc. This in a way modifies the way decision makers perceive flexibility available them in capital budgeting activities
Expanding the way that manager view risk and uncertainty seeing them as phenomena to be appreciated and exploited rather than feared and avoided
- Real analysis allows manager to to evaluate various options available in capital budgeting decisions / activities. They can identify the value of a particular option if implemented vis a vis another option by estimation of the cash flows arising and whether it should be implemented or not. This can provide them an idea of the risks and rewards of each choice available. Hence they can appreciate and explore the choices based on the estimated risk of each choice rather than fear and avoid them altogether.
Making managers aware of the consequences of their decisions and actions on creation or destruction of the value for a capital project.
- Real Analysis can be used by managers for estimating the value of implementing option if any available in capital budgeting activity. This can make them be aware of the consequences of their decisions in creating value or otherwise for a capital project.
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