Accounting assignment on: Real Options Theory

IntroductionReal options are considered as right, not the commitment to take some decisions of the business. This type of option is the actual option which the business might gain by taking certain endeavors (Fuller & Majlender, 2003). There are two common methods such as NPV and analysis of decision tree which could be utilized as methods of valuation for analysis of real options. The theory of real options emerged as the alternative route for evaluation of capital investment decisions of companies. There is one way of dealing with this kind of aspects (mainly uncertainty, irreversibility and investment timings) and to make a same reasoning to investment in the financial options (Fuller & Majlender, 2003). This kind of approach is called as Real Option theory. This new kind of approach fascinated the interests of both researchers and academic practitioners, because it secures the strategic excellence of the investment projects in the uncertain economic environments (Pindyck, 1991). For various companies, real option is taken as the dramatic departure from past which has the possibility to reduce significant concerns, managing vital risks of business or shown exciting opportunities of the growth. For e.g. concerns about their tendency of the managers to undervalue the assets of the firm during the time of divestitures and overpay to assets of other firms during the time of acquisitions or spend in some projects with some strategic advantages which has motivated some companies to examine the utilization of the real options (Fuller & Majlender, 2003). Other firms are encouraged by desire to attain growth opportunities of the new economy or to modify the positions of the industry leadership. In comparison to traditional methods, theory of real options concentrates on valuation of managerial flexibility to respond to distinct situations with great levels of the uncertainty. This kind of theory is called as modern technique for the economic valuation of the projects throughout uncertainty. As per Black and Scholes- the option is considered as security offering the right to sell or buy the assets, subject to some conditions throughout a particular point of time. Option represents rights, and it is examined that yield of the option could never be less than 0, independently of underlying assets. There are 2 kinds of the basic options, one which offer the right to call the assets at the pre-specified price in particular period and other is which offer the right to put the assets in the exchange for obtaining the exercise price in the pre-specified time. When the exercise price of the option is less than the price of underlying assets or more than the existing price of underlying assets, then it is called as options is in money and otherwise out of money.Option could be either American or European. When option could be exercised only on the specified date of future that options are considered as European options.  On other side, when options could be exercised at any point of time up to the date that options are called as American Option. It is examined that value of the European call options could be estimated by using the Black –Schole model. It relies only on 2 variables such as current date, price of underlying assets and 5 parameters such as exercise price of the options, assets volatility, risk-free rate, options expiry date and dividends rate (Pinches, 1982). Real option captures the excellence of the managerial flexibility to accept actions in reaction to unexpected conditions of the market. It is viewed that, conventional capital budgeting presumes management is committed to implementation of the project. Traditional methods are failed to accurately attain the value of decision right of the managers to energetically manage their opportunities of the investment in the environment of rapid change and uncertainty.  The method of real option applies to theory of financial options for assessment of non –financial assets, to assess the excellence of the management in the world of the uncertainty. It reveals the new technique for the management and valuation of the strategic investments. This kind of approach to the investment analysis makes decision makers of the company to leverage the uncertainty and restrict the downside risk.It is utilized as the conceptual technique and permits management to communicate and characterize the strategic excellence of the investment project (Paddock, Siegel & Smith, 1988). Generally, Real option bridges the gap among strategic planning and finance by offering a means to contain both the consequence of the uncertainty comprised in opportunities of the investment and how actions may capitalize on the upside potential (Stark, 1996). This process of the valuation not only educates managers to concentrate on strategic alternatives and distinct opportunities and offers the systematic methodology for measuring the persuasion of the contingent actions on value of the project.  The companies which have shown a broader interest in the real option have certain general characteristics. Generally, companies work in industries where large numbers of investments with unexpected returns are in commonplace like, gas and oil or life science. In certain cases, companies belong to industries which have gone under the structural change which creates techniques of traditional valuation less helpful like industry of electric power. In some organizations, real option is utilized as the input in the M& A process where official numerical evaluation performs a little role. In some cases, real option contributes as the qualitative thinking, with small formality in terms of organizational procedure or analytical rigor. Real option is utilized in the trading environment where option in the contracts is clearly mentioned and simply required to be evaluated (Stark, 1990).   In other companies, real option is utilized in the technology and where the success of the firm is impacted by managing and identifying possible sources of the flexibility.

Various managers are experienced with task of analyzing a specific project with the well –specified kind of flexibility like contract with renewal or exit provisions and the plant with the expansion capability. The application of the techniques of DCF comprises two basic steps: (1) came out with the better estimation of cash flow (2) discounting this estimated cash flow back to present at the risk-adjusted rates. The rate of discount must take into consideration the systematic risks of cash flows. In fact well known formula of Black Scholes could be utilized to offer the quick estimation of value of the real options, but shall be accurate under restrictive situations (Paddock, Siegel & Smith, 1988). The formula could be applied, if there is the single decision to be created regarding the investment at a specific point in future analogous to decide whether to exercise the stock option at its date of maturity or not. The excellence of underlying opportunity which can be received upon exercise should be lognormally distributed.   It can be said that real option is considered as the important technique in valuing of the investments (Myers, 1984). As the result, companies are depending upon the process of investment evaluation made around real options. The accomplishment of the overlay strategy is relied upon nature of current process and kinds of real option tools which are added to that process. Companies which have the legacy of the formal investment assessment under uncertainty have faced success when following an approach of real options.Analysis of Real Option

Real options can be used in various ways such as when there is the contingent decision of the Investment and there is no any other approach which can accurately value this type of chance. When risk is large, it is rational to wait for the more information and this path reverting regret for the irreversible investments (Myers, 1984). On the other side, there are various advantages of Real Option Approach such as it permits active analysis development; it permits the explanation of the optimal decision structures in the innovation projects, it permits incorporating and simulating, evaluation decisions of management to project and it permits the simulation of decision process along with the project life (Miller & Bertus, 2005). There are various techniques, through which we solve real options such as simulation approach, partial differential equation and dynamic approach on programming. It is examined that partial differential equation is one in which value of the option is formed in single equation as the straight function of inputs. Analytical solutions are considered as fastest and easiest way to obtain the option value. On the other side, Simulation Approach finds out potential paths of evolution of underlying assets from present to final date of decision in option (Stark, 1990). Dynamic Programming resolves the problems of how to create optimal actions when current decision persuades future pay-offs.

This diagram shows the optimal decision making process of Options.

It could be stated that analysis of real option is considered as the helpful technique for making decisions of the investment, taking into consideration uncertainty and making flexibility in system. Real Option Analysis deals with the projects which don’t have lots of historical statistics. The Real Option application makes risk use to contribute value to the project and signifies its potential advantages for the decision process of the field development.

Conclusion  

At last, it can be concluded that researchers have a broad variety of the research for the real options.  It could be stated that, knowledge of the real options in several regions is applied from initial B-S option formula and binomial model and transition to compound, multi-stage and models of real options. In fact, theoretical system is developed and its applications associated to various economic fields.  Real option is considered as integrated and comprehensive solution to apply theory of options to value projects of real investment to enhance the process of decision-making. It is very clear that strategic planning requires dynamic and flexible approaches. Calculations of present value are required as the check on the strategy analysis and vice –versa and techniques of discounted cash flows shall required to understate the value of the option attached to developing profitable business lines.

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