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ADVANTAGES OF REAL OPTIONS ANALAYSIS

OVER TRADITIONAL DECISION MAKING TECHNIQUES

Decision makers, analysts, and other finance professionals use DCF analysis,

DTA, and MCS analysis for valuation purposes. Although those may very well serve the

purpose for many applications, their limitations still leave some holes from the valuation

perspective. Miller and Park (2002) define the main limitations of the traditional methods

as follows:

• Selecting an appropriate discount rate poses problems. If the project involves

high uncertainty, a high discount rate, which reflects a high risk premium, is

used.

• Traditional methods ignore the flexibility to modify decisions along the value

chain as new information arrives.

• Investment decisions are typically viewed as now-or-never or go-no-go type

decisions rather than decisions that may be delayed.

Traditional methods use deterministic cash flows, adjusting them for risk utilizing

a constant and risk-adjusted discount rate all along the decision horizon, and subtract the

aforementioned cash flows from the investment outlays for NPV calculation. It should

also be noted that the risks are often hedged by high discount rates and the downswings

are always taken into account undervaluing opportunities.

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ROA, on the other hand, captures the upside potential only by not exercising the

option when the circumstances are unfavorable. ROA only needs the risk-free interest

rate since the risk can be perfectly hedged, and thus there is no need for discount rate

adjustment. In other words, the risk behavior of the decision maker, thus his or her utility

function is not required. Hence it is possible to eliminate subjectivity from the valuation

process.

Traditional methods are unrealistically deterministic, whereas ROA accounts for

managerial flexibility, which is about understanding and managing the risk, as well as

capturing the embedded opportunities or switching between multiple options in a

financial decision problem as new information arrives and resolves uncertainty. Thus,

instead of steering away from uncertainty, decision makers, analysts, and other finance

professionals treat uncertainty as a profit opportunity since ROA enables them to make

intelligent decisions through uncertain market circumstances. In addition to uncertainty,

the length of the decision horizon increases the value of the real options, as well.

However, traditional methods often consider that the long decision horizons have

negative impact on NPV due to increasing uncertainty over time. Kodukula and Papudesu

(2006) argue that ROA accounts for the whole range of uncertainty using stochastic

processes and calculates a quot;compositequot; options value for a project, considering only those

outcomes that are favorable (i.e., options are exercised) and ignoring those that are not by

letting the options expire.

Future cash flows that can be generated by uncertain opportunities are often

ignored through valuation since traditional methods unrealistically require perfect

certainty to evaluate projects. ROA, however, is capable of evaluating projects with

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uncertain payoffs that may occur at uncertain points in time. ROA is more valuable when

embedded options are about delaying, abandoning, and expanding commitments before

making a final decision. Hence, riskier projects become more favorable under uncertain

circumstances especially when they are market-driven. In other words, as new

information arrives and the uncertainty resolves, wait-and-see approach boils down all

possible outcomes into a single scenario, where decision maker may switch to a more

favorable alternative instead of following an irreversible and predetermined decision path

that may end up with a financial loss.

The value of ROA is illustrated with a simple numerical example below. Suppose

that you have a choice between investing $1M in a project today expecting to yield either

$1.6M or $0.8M with 50 percent probability each and delaying that investment by one

year, where the payoff uncertainty clears. The discount rate is given as 10 percent. Using

traditional DCF method, the NPV for the first choice is:

$ 1 .2 M
NPV = − $1M = $0.0909 M
(1 + 0.10 )1
On the other hand, since the uncertainty is expected to clear in one year, the investment

will be made only if the outcome is favorable, which is $1.6M with 50 percent

probability. Thus, the expected NPV for the delayed investment is calculated as follows:

$1.6 M ⎤
⎡ − $1M
= $0.207 M
NPV = 0.5⎢ +
(1 + 0.10) (1 + 0.10)2 ⎥
1
⎦
⎣

The value of delaying the decision is the difference between the two NPV's calculated

above: $0.207M-$0.0909M = $0.1161M.

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Also suppose that the uncertainty is increased. Thus the same project is now

expected to yield either $1.9M or $0.3M with 50 percent probability each and delaying

that investment by one year, where the payoff uncertainty clears. The discount rate is

given as 10 percent. Then the expected NPV for the delayed investment is calculated as

follows:

$1.9 M ⎤
⎡ − $1M
= $0.3306M
NPV = 0.5⎢ + 2⎥
⎣ (1 + 0.10) (1 + 0.10) ⎦
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The value of delaying the decision when the uncertainty is increased is calculated as:

$0.3306M-$0.0909M = $0.2397M. The value of the option is increased by $0.1236M

demonstrating that the ROA generates more favorable results under uncertainty.

References:

[1] KODUKULA, P., and C. PAPUDESU, Project Valuation Using Real Options, J. Ross

Publishing, Inc., Florida, 2006.

[2] MILLER, L., and C.S. PARK, quot;Decision Making Under Uncertainty – Real Options

to the Rescue?,quot; The Engineering Economist, Vol. 47, No.2, 2002, pp. 105-150.

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