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Unit 14: Real Options and Cross-border Investments

on how, over time, actual events have differed from the original forecast. Used in conjunction Notes
with discounted cash flow techniques, real options provide businesses with a model as to how
a certain course of action is likely to impact the business. Without the inclusion of real options,
conventional discounted cash flow techniques can provide an incomplete assessment of the
viability of a project, as they ignore the option to change course during the life of the project,
perhaps taking a charge to abandon, delay, downscale, or even upscale the project.

14.1 Types of Real Options

The flexibility available to management – i.e. the actual “real options” – generically, will relate
to project size, project timing, and the operation of the project once established. In all cases, any
(non-recoverable) upfront expenditure related to this flexibility is the option premium.

14.1.1 Options Relating to Project Size

Where the project’s scope is uncertain, flexibility as to the size of the relevant facilities is valuable,
and constitutes optionality.
Option to Expand: Here the project is built with capacity in excess of the expected level of
output so that it can produce at higher rate if needed. Management then has the option (but
not the obligation) to expand – i.e. exercise the option – should conditions turn out to be
favourable. A project with the option to expand will cost more to establish, the excess
being the option premium, but is worth more than the same without the possibility of
expansion. This is equivalent to a call option.
Option to Contract: The project is engineered such that output can be contracted in future
should conditions turn out to be unfavourable. Forgoing these future expenditures
constitutes option exercise. This is the equivalent to a put option, and again, the excess
upfront expenditure is the option premium.
Option to Expand or Contract: Here the project is designed such that its operation can be
dynamically turned on and off. Management may shut down part or all of the operation
when conditions are unfavourable (a put option), and may restart operations when
conditions improve (a call option). A Flexible Manufacturing System (FMS) is a good
example of this type of option. This option is also known as a Switching option.

14.1.2 Options Relating to Project Life and Timing

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.
Growth options are perhaps the most generic in this category – these entail the option to
exercise only those projects that appear to be profitable at the time of initiation.
Initiation or Deferment Options: Here management has flexibility as to when to start a
project. For example, in natural resource exploration a firm can delay mining a deposit
until market conditions are favorable. This constitutes an American styled call option.
Option to Abandon: Management may have the option to cease a project during its life,
and, possibly, to realise its salvage value. Here, when the present value of the remaining
cash flows falls below the liquidation value, the asset may be sold, and this act is effectively
the exercising of a put option. This option is also known as a Termination option.
Abandonment options are American styled.

Sequencing Options: This option is related to the initiation option above, although entails
flexibility as to the timing of more than one interrelated projects: the analysis here is as to

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