# Real options analysis

In

corporate finance ,**real options analysis**or**ROA**appliesput option andcall option valuation techniques tocapital budgeting decisions. [*Campbell, R. Harvey. [*] A*http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_2002/Identifying_real_options.htm "Identifying real options"*] , Duke University, 2002.**real option**itself, is the right - but not the obligation - to undertake some business decision; typically the option to make, or abandon, a capital investment. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real option.ROA is often contrasted with more standard techniques of capital budgeting (such as

NPV ), where only the most likely or representative outcomes are modelled, and "flexibility" of this type is thus "ignored"; see Valuing flexibility underCorporate finance . ROA is therefore additionally useful in that it forces decision makers to be explicit about the assumptions underlying the projections, and is increasingly employed as a tool inbusiness strategy formulation.**Considerations**In contrast to financial options, a real option is not often tradeable — e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision; however, some real options can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future. Some real options are proprietary (owned or exercisable by a single individual or a company); others are shared (can be exercised by many parties). Therefore, a project may have a portfolio of embedded real options; some of them can be mutually exclusive.

With real option analysis, uncertainty inherent in investment projects is usually accounted for by risk-adjusting probabilities (a technique known as the equivalent martingale approach).

Cash flow s can then be discounted at the risk-free rate. With regular DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate, using e.g. thecost of capital ) or the cash flows (using certainty equivalents). These methods normally do not properly account for changes in risk over a project's lifecycle and fail to appropriately adapt the risk adjustment.Generally, the most widely used valuation methods are:

Closed form solutions,partial differential equations , and the binomial lattices.**History**The terminology "real option" is relatively new, whereas business operators have been making capital investment decisions for centuries. However, the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such, the terminology "real option" is closely tied to these new methods. The term "real option" was coined by Professor

Stewart Myers at theMIT Sloan School of Management in1977 .The concept of real options was popularized by Michael J. Mauboussin, the chief U.S. investment strategist for

Credit Suisse First Boston and an adjunct professor of finance at theColumbia Business School . Mauboussin uses real options in part to explain the gap between how the stock market prices some businesses and the "intrinsic value " for those businesses as calculated by traditional financial analysis, specifically usingdiscounted cash flow s.Real options are today an active field of academic research; one of the leading names in academic real options is Professor

Lenos Trigeorgis (University of Cyprus ). An academic conference on real options is organized yearly (Annual International Conference on Real Options).In business strategy, real options have been advanced by the construction of option space, where volatility is compared with value-to-cost, NPVq. Latest advances in real option valuation are models that incorporate fuzzy logic and option valuation in fuzzy real option valuation models.

**Books***cite book | last=Amram | first=Martha | coauthors=Kulatilaka,Nalin | title=Real Options: Managing Strategic Investment in an Uncertain World| publisher=Harvard Business School Press | location=Boston | year=1999 | id=ISBN 0-87584-845-1

*cite book | last=Copeland | first=Thomas E. | coauthors=Vladimir Antikarov | title=Real Options: A Practitioner's Guide | publisher=Texere | location=New York | year=2001 | id=ISBN 1-587-99028-8

*cite book | last=Dixit | first=A. | coauthors=R. Pindyck | title= Investment Under Uncertainty | publisher=Princeton University Press | location=Princeton | year=1994 | id=ISBN 0-691-03410-9

*cite book | author=Moore, William T. | title=Real Options and Option-embedded Securities | publisher=John Wiley & Sons | location=New York | year=2001 | id=ISBN 0-471-21659-3

*cite book | author=Müller, Jürgen | title=Real Option Valuation in Service Industries | publisher=Deutscher Universitäts-Verlag | location=Wiesbaden | year=2000 | id=ISBN 3-824-47138-8

*cite book | last=Smit | first=T.J. | coauthors=Trigeorgis, Lenos | title=Strategic Investment: Real Options and Games | publisher=Princeton University Press | location=Princeton | year=2004 | id=ISBN 0-691-01039-0

*cite book | author=Trigeorgis, Lenos | title=Real Options: Managerial Flexibility and Strategy in Resource Allocation | publisher=The MIT Press | location=Cambridge | year=1996 | id=ISBN 0-262-20102-X**ee also***Option

*Black-Scholes

*Financial modeling **References****External links*** [

*http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_2002/Identifying_real_options.htm Identifying real options*] , Prof. Campbell, R. Harvey.Duke University

* [*http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/opt.html Applications of option pricing theory to equity valuation*] Prof.Aswath Damodaran ,Stern School of Business

* [*http://www.expectationsinvesting.com/tutorial11.shtml How Do You Assess The Value of A Company's "Real Options"?*] , Prof. Alfred RappaportColumbia University and Michael Mauboussin

* [*http://www.puc-rio.br/marco.ind/tutorial.html Real Options Tutorial*] , Prof. Marco Dias, PUC-Rio

* [*http://sphere.rdc.puc-rio.br/marco.ind/ro-links.html Real Options Selected Links*] , Prof. Marco Dias, PUC-Rio

* [*http://moneyscience.org/home/tiki-read_article.php?articleId=5 Real Options Links and Resources at MoneyScience*]

* [*http://lean.mit.edu/index.php?option=com_docman&task=cat_view&gid=333&dir=DESC&order=date&Itemid=99999999&limit=8&limitstart=8 Strategic Technology Investment Decisions in Research & Development*] David LacknerMIT Lean Advancement Initiative

* [*http://www.financialmodelingguide.com/analytical-tools/real-options/ Real Options in Financial Modeling*]

*Wikimedia Foundation.
2010.*

### Look at other dictionaries:

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