Real Options: Valuing Managerial Flexibility" by Harvard Business School

"Real Options: Valuing Managerial Flexibility" by Harvard Business School

One of the key financial tasks facing managers in their quest to enhance value in an uncertain world is the allocation of resources over their many potential uses. The tools managers use must not only have sound numerical background, but assign some qualitative value on flexibility within the process in order to expand or shrink business' success and failure respectively.

The numerical approach, known as discounted cash flow analysis, uses future cash flows are that summarized by their expected values, and are discounted to the present at a risk-adjusted rate, compared with current costs, yielding a Net Present Value (NPV), a single simple measure for decision making. This analysis takes time and risk into affect. However, it does not deal with management's ability to make decisions to take maximum advantage of the riskiness in the cash flows. An option gives its holder the right, but not the obligation to buy or sell a designated asset at a predetermined price. When managers can choose, rather than be locked into, investment opportunities, payoffs can emerge. Management can actively respond to surprises and somehow avoid NPV<0 outcomes, the true value of its opportunities will be high the standard NPV calculated. Option have value because their terms allow the holder to profit from price moves in one direction without limiting risk in the other direction. Real Options where the underlying assets are real assets, are implicitly held by companies who manage their business and investment opportunities. The 6 types of real options include the following: growth options, option to expand scale, timing, option to switch, option to contract scale, and abandonment options. Expand and growth options take action when