Real Options and Investment Valuation

Abstract

Real options deal with choices about real investments as opposed to financial investments.Although initially applied to mining, oil, and gas projects, real option valuation has since been expanded to address a wide range of managerial choices that affect a company's value.To many financial analysts, the presence of real options is not readily apparent, and even if they are known, most analysts are unclear about how to value such options.This failure leads analysts to incorrectly value companies, and often by a wide margin.With this excellent monograph, Don Chance and Pamela Peterson have produced an invaluable resource to help financial analysts recognize and value real options.They begin by contrasting real option valuation with traditional discounted cash flow methods, and they demonstrate the added flexibility associated with real option valuation.Chance and Peterson next use binomial trees to illustrate the valuation of growth options, deferral options, and abandonment options.Growth options offer management the flexibility to expand the scale of a project.Deferral options enable management to commit quickly while postponing investment to a future date.Abandonment options grant management the flexibility to terminate further investment and to recover any salvage value.Chance and Peterson use the continuous time Black-Scholes model to value the real options associated with Cisco Systems, and they show how real option valuation uncovers value that traditional methods overlook.They are careful, however, to present a balanced view of this important topic by discussing the many challenges associated with real option valuation.They describe, for example, that an increase in volatility raises the value of real options if other factors are held constant.A rise in volatility, however, may raise the discount rate and thus lower the value of the underlying asset, which, in turn, drives down the value of the option.They also point out that real options are not always independent of one another; hence, their values are not additive.Chance and Peterson underscore the fact that many of the underlying assumptions associated with option valuation are not literally true; to wit, returns are not necessarily random nor precisely lognormally distributed, and volatility is not known and constant.Moreover, valuing real options is usually more difficult than financial options because many of the input values, such as exercise price, discount rate, and time to expiration, are not as easily observable.Chance and Peterson are quick to point out, however, that the opaqueness of these values presents a similar challenge to those who rely on traditional valuation methods.They conclude with a review of the empirical research on the accuracy of real option valuation. Foreword ©2002, The Research Foundation of AIMR™ ixEven though real options do not appear on the balance sheet, anyone who is serious about asset valuation must be able to identify and value them.These critical tasks are now much easier thanks to Chance and Peterson's outstanding monograph.The Research Foundation is pleased to present Real Options and Investment Valuation.

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