Aren’t daring, risky projects rewarded in business? How can you quantify payoff and justify a project that is both high-risk and high-return? Real options use decision trees with probability weights to measure the payback of projects. They then discount the future cash flows to reflect the time-value of money.

A simple real option calculation would look like this:

Expected Payoff = (prob success)x(payoff given success) + (prob failure)x(payoff given failure)

For a company undertaking a number of high-risk projects, real options are more accurate than calculating the present value of future cash flows using Net Present Value (NPV) calculation. Projects, unlike bonds do not have a steady and predictable cash flow. The NPV calculation encourages conservative decision making because it does not express the ‘risk of success’ – huge payoffs for wildly successful projects.

Sometimes an investment can have a negative NPV but still has the possibility to offer considerable benefit to a firm. Real options are a better evaluation tool because they take probabilities into account. They reflect the real-world fact that management has a choice to go down one path or another. They are used by companies such as Hewlett Packard, Exxon and… Enron* .

Some ideal applications of real options are:

  • Option to defer (build factory now or later)
  • Option to abandon (stop mining for gold)
  • Option to change operating scale (increase production of pharmaceuticals)
  • Option to default during construction (stop construction of power plants)
  • Option to switch inputs or outputs (change product line)
  • Growth options (planning for wild success vs. moderate)

Imagine you are Electronic Arts and you are releasing a new video game. Can you look into your crystal ball and predict that the game will give you a 10% return over the next two years? No way. No one can predict blockbusters. Hollywood would be a happier place if they could.

Even though it is difficult to predict a guaranteed return, someone during the development phase of the game most likely had to make an estimate of what would happen. Real options gives an executive a good way to reflect the potential success of the project in determining whether to invest further. Management is now faced with the option to invest in development or not. One probability (say 10%) is a “wild success”, as if the new game is the next Sim City, with an enormous payoff associated with it. The other probability (say 70%) is a “modest success”, with some gamers trying it then soon after losing interest, with the moderate payoff associated with it. The rest (say 20%) is a "bust" - the game sucks and no one buys it.

Now, imagine the game is wildly successful. Management will then be faced with another option to invest or not invest in a sequel. Once again real options can help them firgure it out.

Real options can also be used in many real-world scenarios – such as choosing a career. Imagine you have an option to decide whether to be an accountant or a rock star. An accountant would have a steady future income, whereas a rock star could have huge success or end up living modestly. Although the risk-averse person may use the NPV calculation to arrive at the accountant outcome, the risky person could measure the cash value of success, assign a probability and perhaps choose the rock star option logically.

Real options offer some interesting opportunities, but their use is still mostly academic. They have yet to catch on with only 9% of companies using them according to a Bain & Co. survey of 451 companies across 30 industries(CFO Magazine, July 1, 2003).

*although real options valuation is not blamed for Enron’s downfall, their heavy use of them has caused some skepticism.

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