Decision-making is crucial to the long-term success of companies and businesses. Usually, these decisions fall under the responsibility and authority of managers. Through the right choices, companies can grow significantly. However, a wrong decision can also hinder progress substantially. The concept of real options also applies to the decision-making process. Therefore, it is crucial to understand what they are.
What is a Real Option?
A real option is the right to make a business decision. However, it does not constitute an obligation to choose that decision. It also represents the decision alternative available for a tangible asset. Through these options, companies can evaluate various choices. Based on that evaluation, they can choose the right one. This way, companies can ensure future growth and expansion.
With the real options concept, companies can examine a range of possibilities. Once they do so, they can make a choice that is the most beneficial. Similarly, these options allow managers to analyze and evaluate business opportunities. Doing so is crucial for long-term profitability. The real options concept applies to investments and projects. Therefore, they are critical in investment appraisal.
Real options get their name from their application to tangible assets. These options do not apply to financial instruments. In essence, real options are an extension of the financial options concept to real assets. These options extrapolate the definition of financial options to non-financial assets. However, real options differ from financial options contracts since they don't involve exchangeable securities.
How do Real Options work?
Real options allow managers to make decisions in several areas. Through these options, managers can choose between various investment opportunities. However, real options do not oblige them to make a choice. Similarly, it provides them with the opportunity to invest at once or wait for better conditions in the future. Real options are also a part of real options value analysis (ROV).
Real options value analysis involves estimating the opportunity costs of various decisions. With this analysis, managers can evaluate whether to continue a project or abandon it. A real options analysis begins with managers reviewing the risks related to a project. Based on that, they develop models for these risks.
A real options analysis allows managers to be more precise with their decisions. They must evaluate several options and choose an outcome that helps with growth and profitability. Usually, the choices within real options may consist of several scenarios. For example, these may include a decision to expand, abandon, contract, wait, etc.
Example
A company, Red Co., considers a project that will provide a positive NPV of $1 million. However, it can expand its operations through those funds. The expansion process would require more time as well. On top of that, it would also require additional funds to finance the project. Red Co. can choose between the project or expanding its operations.
Within real options, Red Co. can evaluate the choices it has. This process involves assessing both projects and how they will impact their operations. Ultimately, the decision will lie with the company's management. In most cases, it will choose the option with the best outcome.
Conclusion
Real options provide companies with the right to make a business decision. These options apply to tangible assets rather than financial instruments. With these options, companies can evaluate various choices. Based on that evaluation, they can select the option with the most beneficial outcomes. Real options also involve real options valuation.
Originally Published Here: Real Option: Definition, Example
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