Real options are strategic corporate finance tools used to assess investment decisions made under conditions of uncertainty, while financial options tend to focus more on trading activities.
Lean-Agile initiatives often encounter levels of uncertainty where traditional NPV (Net Present Value) estimation methods no longer suffice, necessitating an alternative valuation technique such as Real Options to provide accurate valuation.
1. Uncertainty Management
Uncertainty management theory centers around mitigating uncertainty and taking advantage of any opportunities it presents. Organizations should practice uncertainty management to prepare themselves for unpredictable events while turning threats into strategic advantages.
An innovative framework was devised for identifying and managing uncertainties, consisting of a user interface, database of uncertainties, assessment/prioritisation module, knowledge base of mitigation strategies and an expert consultation panel. This framework was further refined through interviews with stakeholders from both industries and academia to confirm its definitions and concepts.
This framework proved easy to use and understand, helping to reduce ambiguity by translating qualitative judgments into quantitative data sets, as well as providing a platform to judge between uncertainties. Furthermore, this approach offered an easy method for ranking uncertainties according to their impact.
2. Adaptability
Adaptability is the ability to change in response to changing conditions, which is essential for mitigating uncertainty and supporting innovation and flexibility.
Real options theory expands the traditional concept of options valuation used to value tradable securities to tangible or physical real assets like R&D and patents; land and buildings; natural resources like oil-block licenses; manufacturing plants and intangible assets like brand and reputation management processes and flexible human capital. This allows companies to evaluate investment flexibility without taking on obligations for projects with uncertain outcomes and benefits.
Most studies of real option decision making typically measure growth opportunities (Table 2, Panel C). Unfortunately, such metrics rely on an extrapolation from past trends that is at odds with real options thinking.
3. Flexibility
Real options can be an invaluable management tool, helping companies shift from fearing uncertainty and minimizing investment, to taking an optimistic view and seeking gains from it. Real options enable organizations to identify new opportunities, adapt quickly to changing market conditions and reduce risks more efficiently.
Financial options – traded on capital markets with clear terms – provide a useful framework for corporate investment decisions and strategic decision making under uncertainty. Managerial flexibility lies in deferring or staging investments, expanding or growing (such as entering new domestic or foreign markets), contracting or changing uses or abandoning or exiting projects.
Studies show that flexibility strategies can significantly lessen firm value losses during crises. But for full realization of these benefits, firms need to understand how the actions of competitors impact value.
4. Convenience
Real options take option thinking beyond financial markets (where contracts with predetermined terms exist) and apply it to tangible and intangible real assets such as R&D patents, land or property ownership rights, natural resources, manufacturing plants, strategic acquisitions etc.
Value in real assets depends upon their potential for future growth, so our research focused on quantifying such opportunities. For example, revenue generation potential or competitive edge were both considered metrics of assessing this.
One drawback of these measures is their reliance on an assumption of constant market, technology, and consumer demand; using such measurements to guide investment decisions can be inherently risky and may encourage companies to overinvest in potentially lucrative projects. Real options offer managers a way out by giving them flexibility in deferring or abandoning projects altogether.
5. Flexibility
The real option approach measures the value of flexibility and choice when making investment decisions, providing a more comprehensive framework than that used for capital budgeting (net present value (NPV).
Real options offer significant advantages over their derivative counterparts in terms of accessing more opportunities and adapting investments according to results gained from past investments, which increases investment agility while mitigating business risk.
However, it should be remembered that flexibility comes at a cost, which increases risk when investing in new projects. Therefore, it is necessary to carefully weigh all pros and cons associated with any flexibility initiative undertaken; using real option framework can assist companies in making wiser decisions regarding appropriate levels of flexibility.
