Recent developments in the capital budgeting literature opened a new area of investigation into the problem of investment appraisal and business analysis. Real options theory is based on the realisation that when investing in real assets there are certain ways available to the investor similar to investments in financial assets with call or put these ways written on them.
A call option is a right of a small business or company to sell an asset generally at a fixed price. Those decisions that can be exercised at any time during a given period are American options. European options are those that can be exercised only on a particular date. The exercise price is the price paid to exercise one. It is also called the strike price. Values are non-negative, because their pay-offs are either zero or positive by definition.
Five variables determine the value of an option:
1. The price of underlying asset. 2. The exercise price. 3. The rate of interest. 4. The remaining time to maturity or expiration of the option. 5. The volatility of price of the underlying asset.
Similar to call and put options there is, also, the way to embedded in an investment in real assets. Where such choices exist, they are referred to as real options.
Different Real Options:
1. Option to wait (option to defer) - Management has a choice to choose the timing of investment. This type of real option usually occurs in natural - resource extraction, real estate development, farming and fishery industries.
2. Option to Shut Down/ Abandon - This approach emphasizes on the reduction of potential losses as opposed to risk and the increase in firm value implied by the abandonment option. A policy of abandoning an asset one period after abandonment value (AV) becomes greater than present value (PV), AV > PV, would benefit the firm.
Bierman and Schmidt (1988) refer to real options as a choice that an investor has at the time of investment and financial analysis. They argue that an investment project may incorporate different ways, if after the project is accepted there are important decisions that can be made to affect the value of the project. They give an example of this theory to expand, when investment project is successful, choice to sell the project when investment is unsuccessful and, also, consider related businesses based on the experience gained from doing the first project. Brealey and Myers (1996) consider the real options as the right of investors, which they can exercise to capitalise fortune or to mitigate loss.
