Updated: Nov 23, 2020
Many of you hear the name option in finance and investment is relevant to financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
However, do you know option pricing theory can be applied in capital investment decisions as well?
In ACCA Advanced Financial Management (AFM) exam, one of the requirements to assess your advanced investment appraisal skill to apply various option theory in assessing an investment project.
In this article, we tell why there is limitation of conventional investment appraisal method, what is real option and option valuation basis. We also show an example to help you understand how to apply the knowledge.
Limitation of conventional investment appraisal method
Conventional investment appraisal methods, such as Net Present Value (NPV), have continued to be basis for decision-making for companies over a considerable time frame. However, it can be seen that with conventional investment appraisal techniques, there are certain limitations that hamper the overall decisions made in this regard.
Firstly, it can be seen that conventional investment appraisal techniques fail to factor in uncertainty. This is something that is relatively qualitative in how conventional investment appraisal methods are structured.
In several instances, uncertainty, and probabilities alter the outcome of the decision made, because of which companies have to suffer significant financial losses. They are not structured in a manner in which learning is embedded into the overall system.
This tends to be an important parameter, because strategic decisions are not just one-off events. They spread across a longevity, and hence, this timeline is something that should be considered. Conventional Investment Appraisal techniques are often discrete, and provide outcomes in black and white. Therefore, they fail to incorporate any flexibility, and contingencies which are otherwise incorporated in other relevant techniques.
This is also apparent in the manner in which conventional techniques are utilized. For example, in NPV Calculation, present value of cash flows, and present values of fixed costs are considered only. Other models include several other parameters that are meant to offer greater comprehensiveness, and therefore, a better decision making criteria.
What is real option? Why it is helpful in improving NPV limitation?
A Real Option can be defined as an economic right to move forward with a certain deal, or not, based on the decision criteria that is presented to the managers. The decisions that are made relate to business projects, or investment opportunities. It involves having projects that involve tangible assets, as opposed to other financial instruments.
Therefore, the underlying difference between real options and other various financial options is the fact that it involves a properly backed tangible asset, and therefore, they cannot be exchanged like securities.
NPV methodology can be seen that it can be regarded as the safest approach to real options pricing. This is because of the fact that in case of Real Options, it provides a certain degree of flexibility that is not available in cases of conventional NPV methodology.
Speaking of conventional NPV, it is imperative that risks and uncertainties that are related to the project are included in the Cost of Capital. This is done by typing probabilities to certain discrete outcomes, in addition to optional Sensitivity Analysis, or Stress Tests.
On the contrary, with Real Options, risks and other inherent uncertainties are considered as opportunities. This gives flexibility to the organization to choose outcomes that are favorable, and disregard outcomes that are likely to have a negative impact.
In the same manner, it can also be seen that Real Options inculcate a lot more features as compared to conventional investment appraisal techniques. For example, in the case of Net Present Value (NPV) Analysis, it can be seen two main parameters are utilized, which are present value as well as future value. On the contrary, it can be seen that Real Options Pricing includes as many as six parameters. Collectively, they offer a much more comprehensive, and redefined decision making that can help users to make better informed decisions.
Five principal drivers of option value
Black-Scholes Options Pricing is regarded as a viable method to estimate the Option Value. It comprises of five principal drivers:
The underlying asset value – This is considered as the present value of future cash flows that arise from the project.
The exercise price – This is the amount that is paid upon exercising the call option. Alternatively, it is amount that is received if put option is exercised.
The Risk-Free Rate – This rate is mostly taken to be the rate that is offered by short-dated government bill. Regardless of the fact that this is normally the discrete annualized rate, Black-Scholes Option Pricing relies on continuously compounded rates, yet both are considered similar (when it comes to Real Options Valuation)
Volatility – This is referred to as the risk that is attached to the project, or underlying asset. It is measured by the standard deviation.
Time – This is the time frame that is available before the opportunity of exercising that option ends.
Simple illustration of valuing real option
Example: Delaying the decision to undertake a project
A company is considering bidding for the exclusive rights to undertake a project, which will initially cost $35m.
The company has forecast the following end of year cash flows for the four-year project.
The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The likely volatility (standard deviation) of the cash flows is estimated to be 50%.
Solution: NPV without any option to delay the decision
NPV = $5.8m
Supposing the company does not have to make the decision right now but can wait for two years before it needs to make the decision.
NPV with the option to delay the decision for two years
Variables to be used in the BSOP model Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m Exercise price (Pe) = $35m Exercise date (t) = Two years Risk free rate (r) = 4.5% Volatility (s) = 50%
Using the BSOP model
Based on the facts that the company can delay its decision by two years and a high volatility, it can bid as much as $9.6m instead of $5.8m for the exclusive rights to undertake the project. The increase in value reflects the time before the decision has to be made and the volatility of the cash flows.
With fast paced developments in the modern day and age, it is imperative that innovations in decision making finance is something quite crucial to ensure better decision making in the longer run. Utilization of real options for investment appraisals tend to be a prime example showcasing the underlying need to include more well-grounded approaches as a decision making criteria. However, this does not make the conventional systems totally redundant. In fact, it calls for identification of new aspects that can result in better results being generated over the course of time.
Hence, a holistic overview of these decision making parameters is something that is considered to be a differentiating parameter between Real Options, and conventional investment appraisal methods. Flexibility, and uncertainty are the main factors that result in extrapolating results that are far more accurate, and more importantly, realistic. It does not look at these options in a discrete manner, which helps decision makers to get a better, and a deeper insight regarding the viability of the decision that needs to be taken.
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