Chapter

Finance for Engineers

pp 457-503

Real Options Analysis

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Abstract

An option is the right to purchase an asset some time in the future for a price that is settled now. The owner of the option does not have any obligation to do so. Many investment decisions have this same structure: a company has the right to invest in the project, but it has no obligation to do so. By analogy with options traded on the financial markets, not only does the project have value, but also the option to invest in the project. The real option approach recognizes that the options that a company possesses have value. Other forms of management flexibility also have value. For example, management can abandon operations, can switch between products or suppliers, can grow the business, can develop a project in stages and abandon it at any stage to limit loss. All of these actions by management add value because of the flexibility that they represent. The real options approach provides a method for the valuation of these managerial options. It also provides an optimal point to exercise the decision. The options approach has implications for the way in which capital projects are viewed, and how strategy is formulated. In addition to discussing the various methods for the calculation of the value of both financial and real options, this chapter presents a detailed case study that illustrates how they are applied.