[2] A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project.
For example, R&D managers can use real options valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects.
[7][8][9][10] Non-business examples might be evaluating the cost of cryptocurrency mining machines,[11] or the decision to join the work force, or rather, to forgo several years of income to attend graduate school.
[12] It, thus, forces decision makers to be explicit about the assumptions underlying their projections, and for this reason ROV is increasingly employed as a tool in business strategy formulation.
[16] This simple example shows the relevance of the real option to delay investment and wait for further information.
This simple example shows how the net present value may lead the firm to take unnecessary risk, which could be prevented by real options valuation.
In this example, it is studied a staged investment abroad in which a firm decides whether to open one or two stores in a foreign country.
Where the project's scope is uncertain, flexibility as to the size of the relevant facilities is valuable, and constitutes optionality.
[20] Where there is uncertainty as to when, and how, business or other conditions will eventuate, flexibility as to the timing of the relevant project(s) is valuable, and constitutes optionality.
As in the preceding cases, this flexibility increases the value of the project, corresponding in turn, to the "premium" paid for the real option.
[2] ROV is often contrasted with more standard techniques of capital budgeting, such as discounted cash flow (DCF) analysis / net present value (NPV).
Here the approach, known as risk-neutral valuation, consists in adjusting the probability distribution for risk consideration, while discounting at the risk-free rate.
[29] Part of the criticism and subsequently slow adoption of real options valuation in practice and academia stems from the generally higher values for underlying assets these functions generate.
Inputs to the value of a real option (time, discount rates, volatility, cash inflows and outflows) are each affected by the terms of business, and external environmental factors that a project exists in.
[21][31][32][35] The specific application, though, is as follows: The valuation methods usually employed, likewise, are adapted from techniques developed for valuing financial options.
[3] These typically use cash-flow scenarios for the projection of the future pay-off distribution, and are not based on restricting assumptions similar to those that underlie the closed form (or even numeric) solutions discussed.
A more recent approach reformulates the real option problem as a data-driven Markov decision process,[51][52] and uses advanced machine learning like deep reinforcement learning to evaluate a wide range of possible real option and design implementation strategies, well suited for complex systems and investment projects.
These help quantify the value of flexibility engineered early on in system designs and/or irreversible investment projects.
The methods help rank order flexible design solutions relative to one another, and thus enable the best real option strategies to be exercised cost effectively during operations.
These methods have been applied in many use cases in aerospace, defense, energy, transport, space, and water infrastructure design and planning.
[53] The relevance of Real options, even as a thought framework, may be limited due to market, organizational and / or technical considerations.
As discussed above, the market and environment underlying the project must be one where "change is most evident", and the "source, trends and evolution" in product demand and supply, create the "flexibility, contingency, and volatility" [28] which result in optionality.
Finally, even if the firm can actively adapt to market changes, it remains to determine the right paradigm to discount future claims The difficulties, are then: These issues are addressed via several interrelated assumptions: Whereas business managers have been making capital investment decisions for centuries, the term "real option" is relatively new, and was coined by Professor Stewart Myers of the MIT Sloan School of Management in 1977.
Trigeorgis also has broadened exposure to real options through layman articles in publications such as The Wall Street Journal.
[27] This popularization is such that ROV is now a standard offering in postgraduate finance degrees, and often, even in MBA curricula at many Business Schools.
Recently, real options have been employed in business strategy, both for valuation purposes and as a conceptual framework.
[58] Reflecting the "mainstreaming" of ROV, Professor Robert C. Merton discussed the essential points of Arundel in his Nobel Prize Lecture in 1997.
[59] Arundel involves a group of investors that is considering acquiring the sequel rights to a portfolio of yet-to-be released feature films.