The market values a growth company largely by estimating the prospects of its portfolio of growth projects. These projects—research and development, investments in new capacity, geographical expansion, and other initiatives—are seldom simple onetime decisions; in most cases, a company’s investments are multistaged, and at each step the company may push ahead or pull out after gaining new information. These projects are thus options—“real” options, as opposed to financial options—in which managers have the right but not the obligation to invest. It’s therefore appropriate that managers have begun to apply option theory to help them make decisions about these projects. Indeed, a survey of 4,000 CFOs published in 2001 by John Graham and Campbell Harvey found that 27% of the respondents claimed they “always or almost always” used some sort of options approach to evaluating and deciding upon growth opportunities.
A Real-World Way to Manage Real Options
Reprint: R0403G
Each corporate growth project is an option, in the sense that managers face choices—push ahead or pull back—along the way. Yet many companies hesitate to apply options theory to initiatives such as R&D and geographic expansion, partly because these “real” options are highly complex. In this article, the authors make the case that the complexity of real options can be eased through the use of a binomial valuation model.
Many of the problems with real-options analysis stem from the use of the Black-Scholes-Merton model, which isn’t suited to real options. Binomial models, by contrast, are simpler mathematically, and you can tinker with a binomial model until it closely reflects the project you wish to value. Suppose your company is considering investing in a new plant. To use the binomial model, you must create an “event tree” to figure out the full range of possible values for the plant during the project’s lifetime—next year, at the end of the design phase, upon completion. Then you work backward from the value at completion, factoring in the various investments, to determine the value of the project today. These calculations provide you with numbers for all the possible future values of the option at the various points where a decision needs to be made on whether to continue with the project.
The authors also address another criticism of real options: that gaps often arise between theoretical and realized values of options of all types. Such gaps may be largely the result of managers exercising options at the wrong time. To improve the way it manages its real options, a company can look out for the decision trigger points that correspond to the nodes on a binomial decision tree. The trigger points should not only tell managers when they need to decide on exercise but also specify rules governing the exercise decisions.
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