Page 235 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes whether it is advantageous to implement these sequentially or in parallel. Here, observing
the outcomes relating to the first project, the firm can resolve some of the uncertainty
relating to the venture overall. Once resolved, management has the option to proceed or
not with the development of the other projects. If taken in parallel, management would
have already spent the resources and the value of the option not to spend them is lost.

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Caution The sequencing of projects is an important issue in corporate strategy. Related
here is also the notion of Intraproject vs. Interproject options.

14.1.3 Options Relating to Project Operation

Management may have flexibility relating to the product produced and/or the process used in
manufacture. This flexibility constitutes optionality.

Output Mix Options: The option to produce different outputs from the same facility is
known as an output mix option or product flexibility. These options are particularly
valuable in industries where demand is volatile or where quantities demanded in total for
a particular good are typically low, and management would wish to change to a different
product quickly if required.

Input Mix Options: An input mix option – process flexibility – allows management to use
different inputs to produce the same output as appropriate. For example, a farmer will
value the option to switch between various feed sources, preferring to use the cheapest
acceptable alternative. An electric utility, for example, may have the option to switch
between various fuel sources to produce electricity, and therefore a flexible plant, although
more expensive may actually be more valuable.

Operating Scale Options: Management may have the option to change the output rate per
unit of time or to change the total length of production run time, for example in response
to market conditions. These options are also known as Intensity options.
Self Assessment

Fill in the blanks:
1. In Option to …………………… management may have the option to cease a project during
its life, and, possibly, to realise its salvage value.

2. …………………… options is related to the initiation option above, although entails
flexibility as to the timing of more than one interrelated projects
3. Output …………………… options produce different outputs from the same facility is known
as an output mix option or product flexibility.
4. An …………………… mix option process flexibility – allows management to use different
inputs to produce the same output as appropriate.

14.2 Valuation

It is clear that there is an analogy between the modelling of real options and financial options.
At the same time, it is nevertheless important to understand why the more standard valuation
techniques may not be applicable for ROV.

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