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Real option perceptions among project managers
Abstract
Effective and efficient planning for and management of project risk requires the management of uncertainty. Real options can be an effective tool for managing uncertainty and thereby increasing project value. As most managers do not use real options, but instead intuitively manage uncertainty, understanding the similarities and differences between decision-maker perceptions of real options and real options theory is critical for improving the use of real options for risk management. In the current work, an experiment using a simple uncertain development project and a simulation model capture managers' perceptions of real options, including option values. Results show that subjects valued flexibility and conceptually understood option values in ways consistent with theory. Implications for real options research and development are discussed.
... Despite the increasing attention given to real options thinking in project management literature, it has not yet been studied in healthcare real estate management. Besides, as authors such as Ford and Lander (2011) point out, real options models have been applied in practice to a limited extent. It is therefore useful to find out how practitioners deal with flexibility. ...
... Referring to Triantis (2005), Ford and Lander (2011) also emphasize the importance of knowing how practitioners perceive and value flexibility. By investigating the practice of real estate managers in health, which is a still unexplored research area regarding real options, we investigate whether real options reasoning is also used in this field and how it can be made explicit for improved risk management. ...
... However, it is also one of the sectors that does not use real options tools like Triantis (2005) described. This research created more understanding on how practitioners deal with flexibility and real options, which is one step towards applying real options thinking in practice, as suggested by Triantis (2005) and Ford and Lander (2011). ...
Objective:
Exploring the impact of the type of project coalition on types of flexibility by analyzing considered and exercised flexibilities in separated and integrated project coalitions in the design and construction phase and the operations and maintenance phase of a healthcare construction project.
Background:
Flexibility in healthcare construction projects is increasingly needed in order to deal with growing uncertainties. Until now, little research has been carried out on how and to what extent flexibility is incorporated in different types of project coalitions chosen by healthcare organizations.
Methods:
An exploratory survey was conducted among health organizations in both cure and care. Questions were asked on the position of the real estate department within the organization, the type of project coalitions chosen and the rationale behind this choice, and the extent to which flexibility in terms of a real option was considered and to what extent it had been exercised in a project coalition.
Results:
Integrated project coalitions pay more attention to flexibility in advance in both the process and the product, but exercise them to a lesser extent than separated project coalitions. The economic feasibility of real options is higher in integrated project coalitions.
Conclusions:
The study shows that real options thinking is already incorporated in real estate management of healthcare organizations, although more flexibility is considered in advance of the project than is actually realized during and after construction.
Keywords:
Built environment, construction, decision making, hospitals, planning.
... Despite the increasing attention given to real options thinking in project management literature, it has not yet been studied in healthcare real estate management. Besides, as authors such as Ford and Lander (2011) point out, real options models have been applied in practice to a limited extent. It is therefore useful to find out how practitioners deal with flexibility. ...
... Referring to Triantis (2005), Ford and Lander (2011) also emphasize the importance of knowing how practitioners perceive and value flexibility. By investigating the practice of real estate managers in health, which is a still unexplored research area regarding real options, we investigate whether real options reasoning is also used in this field and how it can be made explicit for improved risk management. ...
... However, it is also one of the sectors that does not use real options tools like Triantis (2005) described. This research created more understanding on how practitioners deal with flexibility and real options, which is one step towards applying real options thinking in practice, as suggested by Triantis (2005) and Ford and Lander (2011). ...
Uncertainties affecting health organizations inevitably influence real estate decisions since real estate is required to facilitate the primary process in cure and care. Decisions have to be taken when there is little knowledge about the future. Therefore, flexibility is needed in the process of designing, constructing and operating real estate. Real options provide an approach to gain greater insight into flexibility. The aim is to analyse whether real options can be recognized in the real estate strategies of health organizations and what real options are provided by various forms of project coalition. Two case studies reveal that real options thinking can indeed be recognized in specific real estate strategies. The choice of certain real options is partly a result of the type of project coalition applied. Further development of real options thinking in real estate management in cure and care creates opportunities to deal with future uncertainties.
... In contrast, uncertain material prices can increase profits for a lump sum contractor if those prices drop after bidding and before material purchases. Whether handling uncertainty is considered risk management or benefit enhancement is based largely on targets and perspective (Ford and Lander, 2011). In spite of this, successfully managing uncertainties is critical for project success. ...
... Similarly, research in academic settings within the engineering and infrastructure disciplines continues (e.g. Mattar and Cheah, 2006;Chiara et al., 2007;Brandao and Saraiva, 2008;Tseng et al., 2009;Menassa et al., 2010;Shan et al., 2010;Ford and Lander, 2011). Evidence also exists that improved management of uncertainty would bolster infrastructure project performance. ...
Developed from financial options theory and pricing models, real options have evolved to become a mainstream area of academic inquiry. This account traces the field generally from its origins to present day. Research has demonstrated the potential for real options to enhance project value by managing uncertainty through investment, structuring and design decisions. Despite this, real options theory is not widely used as a whole or within the discipline of infrastructure development and construction project management. The creation of infrastructure occurs almost exclusively in a project-based environment. Not surprisingly, project managers play a pivotal role in the success of such projects and make frequent decisions that shape and reshape implementation strategies. Perhaps, the path towards disseminating real options into infrastructure project practice is to improve the understanding of the managerial environment and behaviour. Hence, the characteristics of infrastructure projects and project management underpin six propositions, which need further investigation to aid bridging the chasm between the notion of real options and its application in actual project settings. Each proposition is linked to the literature and project management practice.
... In contrast, uncertain material prices can increase profits for a lump sum contractor if those prices drop after bidding and before material purchases. Whether handling uncertainty is considered risk management or benefit enhancement is based largely on targets and perspective (Ford and Lander, 2011). In spite of this, successfully managing uncertainties is critical for project success. ...
... Similarly, research in academic settings within the engineering and infrastructure disciplines continues (e.g. Mattar and Cheah, 2006;Chiara et al., 2007;Brandao and Saraiva, 2008;Tseng et al., 2009;Menassa et al., 2010;Shan et al., 2010;Ford and Lander, 2011). Evidence also exists that improved management of uncertainty would bolster infrastructure project performance. ...
Abstract The limited,adoption,and,use,of,real options,by,practicing managers,in,the architecture/engineering/construction (AEC) industry remains an important challenge. This
... In the literature, much is still discussed about the practical value of ROA (Smith andNau 1995, Ford andLander 2011). Garvin and Ford (2012) demonstrated the potential of real options regarding the management of uncertainties and flexibilities in infrastructure projects. ...
In countries where transportation infrastructure is underdeveloped, newly built facilities tend to attract and increase demand. This can lead to situations where future traffic levels exceed the concession capacity limit, and additional investments in expansion is required. One common solution is to mandate this investment as a firm obligation in concession contracts, either after a set number of years or when demand reaches capacity. In this article, we show why these policies are suboptimal and propose a model that combines flexible capacity expansion decisions with conditional term extensions. We model this flexibility under the real options approach and the project value uncertainty during the life of the concession as a Brownian Bridge. As a novel contribution, we take into account the fact that concession revenues are bounded by the current traffic capacity of the road, which represents an upper absorbing barrier that has implications for the expansion decision. As a numerical application, this model is applied to a typical toll road project in Brazil. The results show that flexible expansion policies, coupled with conditional term extensions, have significant advantages. These findings can be of use to government officials involved in developing policies to attract private investment in public infrastructure projects.
... In the literature, much is still discussed about the practical value of ROA (Smith andNau 1995, Ford andLander 2011). Garvin and Ford (2012) demonstrated the potential of real options regarding the management of uncertainties and flexibilities in infrastructure projects. ...
... The study concluded that firm's size and education of the chief executive officers influenced financial decisions in corporate organizations. Ford and Lander (2011) analysed the perception of project managers to the use of ROA. The findings revealed that respondents intuitively value flexibility and conceptually understood the underpinnings of the real options framework in a manner consistent with the real options theory. ...
Arising from the growing academic discourse on the inadequacies of the traditional investment techniques, and the benefits of the real option analysis (ROA) in investment appraisal, most investment appraisers are still unwilling to incorporate ROA into the appraisal practice. This study examines the factors influencing the adoption of ROA in development appraisal in an emerging market like Nigeria. Primary data employed for the study was obtained through questionnaire administered on the property development/appraisal officers at the head offices of the estate surveying and valuation (ESV) firms and the property development companies (PDCS) in three first tier property markets of Lagos, Abuja and Port Harcourt in Nigeria. Statistical techniques such as Mean rating, frequency distribution and principal component analysis were employed. The result of the mean analysis reveals that client, market and individual factors were major constraining influences. However, the PCA reveals that firm/management factors, individual factors, client factors and computational/market factors were the major factors influencing the choice of real estate development (RED) appraisal techniques in the Nigeria emerging market. These have variances of 15.767%, 12.895%, 7.818% and 6.992% respectively. The study concluded that while the individual appraiser may not be able to act outside of the company’s/firms policies, there is a need for a paradigm shift within the RED industry to be able to meet up with contemporary demands with respect to RED appraisal techniques and increasing market and investors sophistication.
... In the literature, much is still discussed about the practical value of ROA (Smith andNau 1995, Ford andLander 2011). Garvin and Ford (2012) demonstrated the potential of real options regarding the management of uncertainties and flexibilities in infrastructure projects. ...
Infrastructure projects have as characteristics a long maturation period and high capital investments, which generates significant risks. Government Grants or Concessions, as well as Public Private Partnerships (PPPs), are usually bound by a time term defined in the contract, during which the private party must get its payback and return on invested capital. Although the objectives of both sides (public and private) are oppositely different, they need not be antagonistic as they both get to profit from the other in the project involved. When well designed, the contract rules should guarantee the smooth development of the concession, bringing about a win-win partnership. Capacity expansion, especially in infrastructure concessions such as roads, ports, trains, airports, among others, should be driven by the demand and decided by the concessionaire, since it is an intensive capital decision and is subject to a time frame limit. We argue in this research that in order to optimize such a financial decision, which finally should be beneficial to both parties involved, an investment in capacity expansion should not only be decided by the concessionaire, evidently under previously designed contract rules, but also permit extension of the time grant in order to turn it financially viable for the investor, even if close to the end of the contract term. In this sense, the purpose of this article is to model, through the real options approach, different policies of capacity expansion option in governmental concession grants.
Project Risk Management contains processes ranging from planning to control. It is applied to identify risks, analyze them, and design responses to change the occurrence rate and/or the effect of project risks. It is important for project managers to analyze the effects of the risks in projects and also consider project risks in their decisions. If project risks are not addressed during the risk management process, issues such as schedule delays, cost overruns, and even project failure may occur. This paper aims to introduce a Markov method to integrate project risk analysis and risk response planning. This method is applied to forecast the following status of the project when limited information about the project is available. Moreover, earned value management (EVM) methods were used to include various types of project risks through the project lifecycle. The model also offers the capability to choose the most effective risk response for managing project risks through the application of the Markov decision process (MDP). Eventually, we introduce a case study to demonstrate functionality and effectiveness of the presented approach. Solving the model allows for identifying the best set of risk response strategies tailored to each specific project state. The computational results illustrate that the current state of the project has a significant impact in the process of risk response planning. Since uncertainty is the inherent characteristic of projects, the use of the project’s current state is more reliable than the previous status of projects, and the Markov method is applied in this research because it uses the current state for its modelling. Using this method, managers can predict the future state of projects and find the best response in each status of projects.
Engineers, mathematicians and other experts have devised many tools to help us understand uncertainty and to evaluate and mitigate risk. The oil industry is permeated by uncertainty and encounters risk at every turn, yet many oilfield decision-makers, perhaps most, give the new techniques a wide berth.
A new trend in corporate planning is to exploit uncertainty by taking investment opportunities as real options. This options approach is to complement the conventional net present value (NPV) criterion in evaluating risky investments. In this paper, we take a broad look at the real options approach to various engineering economic decision problems, laying out how it provides an immediate and important perspective on value creation in an uncertain world. Unlike financial options, real options analysisdeals with investments in real assets, which is one of the primary interest areas in engineering economics. For that reason, we believe that any advancement in the real options decision framework will benefit the field of engineering economics.
The strategy literature is increasingly focused on the need to create dynamic capabilities to respond with innovative product offerings in 'hypercompetitive' environments. The real options approach offers hope for managers facing such threatening environments by highlighting methods to hold options on a variety of possible future states, thereby reducing risk without bearing all the costs. However, extant real options literature, stemming from rational-based financial assumptions, does not consider attention as a limited resource. Real options are valued on the assumption that management can exploit the flexibility inherent in projects, and so require management attention to obtain their full theoretical value. This paper brings attentional constraints to bear on the real options framework and describes a conceptual framework that illustrates the real option value realization process.
Managerial flexibility has value in the context of uncertain R...D projects, as management can repeatedly gather information about uncertain project and market characteristics and, based on this information, change its course of action. This value is now well accepted and referred to as "real option value." We introduce, in addition to the familiar real option of abandonment, the option of corrective action that management can take during the project. The intuition from options pricing theory is that higher uncertainty in project payoffs increases the real option value of managerial decision flexibility. However, R...D managers face uncertainty not only in payoffs, but also from many other sources. We identify five example types of R...D uncertainty, in market payoffs, project budgets, product performance, market requirements, and project schedules. How do they influence the value from managerial flexibility? We find that if uncertainty is resolved or costs/revenues occur after all decisions have been made, more variability may "smear out" contingencies and thus reduce the value of flexibility. In addition, variability may reduce the probability of flexibility ever being exercised, which also reduces its value. This result runs counter to established option pricing theory intuition and contributes to a better risk management in R...D projects. Our model builds intuition for R...D managers as to when it is and when it is not worthwhile to delay commitments---for example, by postponing a design freeze, thus maintaining flexibility in R...D projects.
The field of real options has been slow to develop because of the complexity of the techniques and the difficulty of fitting them to the realities of corporate strategic decision-making. Such complexity, and the resulting challenge of getting senior management “buy-in,” has been a major barrier to wider corporate adoption of real option techniques.
To overcome this barrier, The Boeing Company has invested heavily to develop state-of-the-art methods and tools. The goal is to create a real options approach that uses the language and frameworks of standard DCF analysis—a framework the company’s financial analysts and managers are already familiar with and feel comfortable using. The result has been a method of valuation (referred to at Boeing as the “DM” Method that, while algebraically equivalent to the Black-Scholes formula for valuing financial options, uses information that arises naturally in a standard DCF project financial valuation.
Real operating (flexibility) options embedded in a technology investment are valuable because they allow management to take rational, value-adding actions that could favorably affect operational traits of the investment (timing, scale, scope, etc.). These options, however, are not inherent in technology investments. Rather, they usually must be carefully planned and designed to fit each investment differently. Building on concepts from the area of financial risk management, this paper presents a methodology for planning the creation of specific operating options designed to maximize the value of a technology investment in light of the risks underlying that investment. The paper also illustrates the use of the methodology in the context of a Web-based information technology investment.
The book is based on an international research project that analyzed sixty LEPs, among them the Boston Harbor cleanup; the first phase of subway construction in Ankara, Turkey; a hydro dam on the Caroni River in Venezuela; and the construction of offshore oil platforms west of Flor, Norway.
As the number, complexity, and scope of large engineering projects (LEPs) increase worldwide, the huge stakes may endanger the survival of corporations and threaten the stability of countries that approach these projects unprepared. According to the authors, the "front-end" engineering of institutional arrangements and strategic systems is a far greater determinant of an LEP's success than are the more tangible aspects of project engineering and management. The book is based on an international research project that analyzed sixty LEPs, among them the Boston Harbor cleanup; the first phase of subway construction in Ankara, Turkey; a hydro dam on the Caroni River in Venezuela; and the construction of offshore oil platforms west of Flor, Norway. The authors use the research results to develop an experience-based theoretical framework that will allow managers to understand and respond to the complexity and uncertainty inherent in all LEPs. In addition to managers and scholars of large-scale projects, the book will be of interest to those studying the relationship between institutions and strategy, risk management, and corporate governance in general.
Contributors Bjorn Andersen, Richard Brealey, Ian Cooper, Serghei Floricel, Michel Habib, Brian Hobbs, Donald R. Lessard, Pascale Michaud, Roger Miller, Xavier Olleros
Risk looms large at almost every stage of the oil business, from exploration and production to marketing. Assessing risk and uncertainty aids decision-making and can help improve exploration and production performance. The tools that are used to cope with physical risk and uncertainty can also be used to understand economic risk and uncertainty, but they seldom are. This article discusses the latest tools for economic evaluation and risk assessment of proposed investments in oilfield projects, including discounted cash flow, Monte Carlo analysis, and portfolio, options and preference theories.
This compilation integrates various new contributions to the growing real options literature. Recent developments in the valuation of capital investment opportunities seen as real options (e.g. to defer, expand, abandon, or switch) have provided the tools and unlocked the possibilities to revolutionize the field of capital budgeting. The resulting insights, strategies, and techniques enable quantifying the thus far elusive elements of managerial operating flexibility and strategic interactions. These are vital to successfully capitalize on favorable future investment opportunities or limit losses from adverse market developments. This book presents various models and operating strategies, and a variety of applications ranging from acquisitions and divestitures, to natural resource development and pollution compliance. It is intended for both the academic and the professional market.
The book's contributions are divided into five parts, covering sections on real options and alternative valuation paradigms for capital investment analysis; on the analysis of general exchange or switching options, and interdependencies among multiple such options; on strategic acquisitions, infrastructure, and foreign investment options; on mean reversion/ alternative formulations in natural resource investments, shipping, and start-up ventures; and on other applications in pollution compliance, land development, flexible manufacturing, and financial default options. Both academic and practitioner interest in these developments is unusually high. The book can serve as supplementary material for the academic market, e.g., in advanced finance courses in option pricing or capital budgeting, in doctoral seminars, and as a library resource. It may also be of interest to the professional market (e.g. corporate planners and finance executives in the oil, pharmaceutical, auto and a variety of other industries), academics from related areas (e.g. decision analysts or economists), as well as to international readers (academics, doctoral students, and professionals).
The limited adoption and use of real options by practicing managers in the architecture/engineering/construction (AEC) industry remain an important challenge. This chapter describes a risk-rich managerial practice in which real options can add value but are not fully exploited. This setting is used as a basis for identifying and describing specific barriers to widespread real options adoption and use by practicing project managers. These barriers are used to suggest tools, methods, and approaches that may reduce those barriers.
The inability of classic NPV analysis to capture the future value of options in a capital budgeting analysis is now well documented by Trigeorgis (199312.
Trigeorgis , L. 1993. Topics in real options and applications. Financial Management, 22(3): 202–223. View all references, 200514.
Trigeorgis , L. 2005. Making use of real options simple: An overview and applications in flexible/modular decision making. The Engineering Economist, 50(1): 25–53. View all references), Copeland and Antikarov (2001)4.
Copeland , T. and
Antikarov , V. 2001. Real options: A practitioner's guide, New York: TEXERE LLC. View all references, and others. In spite of this, traditional NPV analysis continues to be described as a normative approach. The author surveys Fortune 1,000 companies to see if they have picked up on the use of real options to complement traditional analysis. Out of 279 respondents, 40 were currently using real options (14.3%). While the percentage is small, the number is higher than in previous studies. The author goes on to describe in what manner real options are being used and, of equal importance, why they are resisted by many. Somewhat encouraging is the intent of well over half the nonusers to consider the use of real options in the future.
This article focuses on how the use of real options can be made simple, providing an overview of the power of flexible and modular decision making and its use in various applications across industries. After common real options are discussed through a comprehensive example, the article reviews the key lessons and implications of real options thinking for flexible decision making. It then proceeds to propose a modular problem structuring approach that allows simplifying of complex real option problems by decomposing them into a few basic building-block option types (reviewed) connected by some basic decision operators. The resulting problem-structuring option map is depicted in a range of illustrative applications in various industries. Past areas of application of real options as well as research challenges ahead are also discussed.
Most discussions of capital budgeting take for granted that discounted cash flow (DCF) and real options valuation (ROV) are very different methods that are meant to be applied in different circumstances. Such discussions also typically assume that DCF is “easy” and ROV is “hard”—or at least dauntingly unfamiliar—and that, mainly for this reason, managers often use DCF and rarely ROV. This paper argues that all three assumptions are wrong or at least seriously misleading.
DCF and ROV both assign a present value to risky future cash flows. DCF entails discounting expected future cash flows at the expected return on an asset of comparable risk. ROV uses “risk‐neutral” valuation, which means computing expected cash flows based on “risk‐neutral” probabilities and discounting these flows at the risk‐free rate. Using a series of single‐period examples, the author demonstrates that both methods, when done correctly, should provide the same answer. Moreover, in most ROV applications—those where there is no forward price or “replicating portfolio” of traded assets—a “preliminary” DCF valuation is required to perform the risk‐neutral valuation.
So why use ROV at all? In cases where project risk and the discount rates are expected to change over time, the risk‐neutral ROV approach will be easier to implement than DCF (since adjusting cash flow probabilities is more straightforward than adjusting discount rates). The author uses multi‐period examples to illustrate further both the simplicity of ROV and the strong assumptions required for a typical DCF valuation.
But the simplicity that results from discounting with risk‐free rates is not the only benefit of using ROV instead of—or together with—traditional DCF. The use of formal ROV techniques may also encourage managers to think more broadly about the flexibility that is (or can be) built into future business decisions, and thus to choose from a different set of possible investments. To the extent that managers who use ROV have effectively adopted a different business model, there is a real and important difference between the two valuation techniques. Consistent with this possibility, much of the evidence from both surveys and academic studies of managerial behavior and market pricing suggests that managers and investors implicitly take account of real options when making investment decisions.
Infrastructure facilities are generally heavy, fixed, and normally irreversible once construction has been completed. As existing facilities, they may confront economic competition of an increased space demand and the need for future expansion. Due to economic-based irreversibility, the expansion of a constructed facility requires the foundation and, to a lesser degree, columns to be enhanced and options for expansion to be accounted for at the very beginning of construction. Enhancing the foundation and columns represents an up-front cost, but has a return in flexibility for future expansion. This trade-off can be viewed as an investment problem, in that a premium has to be paid first for an option that can be exercised later. A model of the foundations versus flexibility trade-off enables the competing options to be optimized by balancing the expected profits that may arise from future expansion, i.e., the value of flexibility, and the cost of enhancing the foundation. Use of the model is demonstrated for the construction of a public parking garage, with the optimal foundation size determined. The evolution of parking demand is modeled with a trinomial lattice. Stochastic dynamic programming is used to determine the optimal expansion process. A model that does not consider the value of flexibility is compared with two value-flexible models. The value of flexibility in this case study is so significant that failure to account for flexibility is not economical. Valuation modeling such as discounted cash flow analysis with uncertainty modeling is important to capitalize on the worth of flexibility.
Purpose
– Construction strategies for competitive bidding and operations are used to avoid the consequences of poor schedule performance such as delay penalties. Flexible strategies in the form of options can increase project value if uncertain conditions cannot be adequately forecast before operations begin. However, project management purposefully manipulates the project performance that drives the use of options and thereby the value added by options. Therefore project management quality may influence option values. Seeks to address this question.
Design/methodology/approach
– This research investigates the interaction of project management and option value by operationalizing a common use of real options in construction and valuing the option with different levels of project management quality. A simple but realistic dynamic simulation model of a project is described and exercised to reveal some impacts of project management on option value.
Findings
– The results support a hypothesis that increased project management quality decreases option value and that real options in managing construction projects can be explained with real options theory. The model structure suggests causal explanations that are consistent with real options theory.
Originality/value
– The results suggest that practising managers can significantly increase project value by structuring managerial flexibility and thereby improving their evaluation, development, and use of flexibility. However, ignoring the multiple means of managing uncertainty that are often available can distort valuation. Results also suggest that researchers of strategic flexibility in projects should consider multiple forms of uncertainty in modeling options. Increasing the number of available options or the effectiveness of options in a multiple‐option environment can decrease individual option values.
This article develops an option-theoretic perspective for organizational strategic management. Grounded in the basic intuition that people seek to "keep options open" in situations that involve an unforeseeable future, and supported by theory in financial economics, this view is a recent development in strategy. The theory integrates resource allocation, sense making, organizational learning, and strategic positioning in a unified framework, and it provides a new explanation for some counterintuitive empirical findings.
The Real Options paradigm addresses the valuation of managerial flexibility in capital budgeting. Despite the great strides achieved by researchers in this field, many financial analysts have chosen not to adopt this new paradigm due to a lack of comfort with the approach and the mathematical complexity of the valuation models. This article shows how some projects with real options can be valued using simple and familiar tools-discounting expected cash flows after adjusting the discount rate. Unless the discount rate is adjusted to account for the impact of real options on risk, a traditional net present value (NPV) analysis misses the value of flexibility. By narrowing the gulf between Real Options analysis and more familiar tools, the weighted average discount rate (WADR) approach introduced in this paper may help novices better understand die Real Options paradigm, which subsequently may gain the wider acceptance it deserves. Though the WADR approach is practical only for simple real options, comfort with the approach may encourage analysts to pursue more advanced and robust real option valuation techniques for more complex applications.
The current work examines the application of system dynamics to real options through work with a major energy firm to apply real options. Five key challenges facing the real options community are presented and potential system dynamics contributions to these challenges are discussed. Two cases from a BP research project illustrate how system dynamics can be used to develop and value real options. The work shows that the use of systems dynamics in real option development and valuation can 1) address key challenges facing the real options community and increase the use of real options in the oil and gas industry 2) allow system dynamicists to offer increased value in developing and valuing flexibility and 3) open system dynamics to new markets of research collaboration and potential clients.
In this paper we use a real options approach to value pilot project investments that help reduce idiosyncratic uncertainty with respect to the final costs of a project. We develop a general one period investment model and, using standard financial engineering techniques, are able to find the value of these investment opportunities and the corresponding optimal investment level. In our setting, both tradable market uncertainty and idiosyncratic technical uncertainty affect the value of the project, with the latter being driven by the amount invested in the pilot stage. Learning is modeled using a proportionality assumption between investment in the development stage and resolution of technical uncertainty. The coefficient that governs this proportionality relation will play a key role in our model, as it defines whether there are decreasing or increasing marginal returns to investment in the development stage and to what extent. Interesting economic implications concerning the effects of this learning coefficient and other parameters of interest in the optimal investment decision are obtained. The robustness of our results is also analyzed. Finally, applications of our framework to investment decisions in various industries and across the supply chain of firms are discussed.
We survey a large sample of Canadian firms to first learn whether they use real options, the types of real options used, and why firms do not use them. Only 36 of the 214 respondents (16.8%) report using real options, which ranks last among nine capital budgeting techniques. The main reason for using real options is to provide a management tool to help form a strategic vision. The most commonly used real options are growth options and options to defer. Managers report that a lack of expertise and knowledge prevents them from using real options. Our evidence suggests that contrary to optimistic predictions, the use of real options appears disproportionate to their potential as a capital budgeting tool.
Despite widespread application of real options theory in the literature, the extent to which firms actually delay irreversible investments following an increase in the uncertainty of their environment is not empirically well-known. This paper estimates firms’ responsiveness to changes in uncertainty using detailed data on oil well drilling in Texas and expectations of future oil price volatility derived from the NYMEX futures options market. Using a dynamic model of firms’ investment problem, I find that oil companies respond to changes in expected price volatility by adjusting their drilling activity by a magnitude consistent with the optimal response prescribed by theory.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
One of the most successful areas for the application of system dynamics has been project management. Measured in terms of new system dynamics theory, new and improved model structures, number of applications, number of practitioners, value of consulting revenues, and value to clients, “project dynamics” stands as an example of success in the field. This paper reviews the history of project management applications in the context of the underlying structures that create adverse dynamics and their application to specific areas of project management, synthesizes the policy messages, and provides directions for future research and writing. Copyright © 2007 John Wiley & Sons, Ltd.
This book is about the real options approach to strategic investments, showing how to capitalize on uncertainty through strategic investments, contracts, and use of the financial markets.
This article uses the extended case method to explore senior executives' corporate finance decisions. We quantified firm's finance practices using a mail survey, and then - to resolve puzzles in managers' decision processes - conducted face-to-face interviews with chief finance officers of large listed firms. The interviews identified six themes as consistent influences on finance decisions: pressures imposed by clienteles; constraints on resources; risk management; heuristics; real options; and sustainability. We conclude that managers are logical and rational in their decisions, but employ a wider range of criteria than assumed in conventional finance theories. Copyright (c) 2010 The Authors. Accounting and Finance (c) 2010 AFAANZ.
Traditional project evaluation based on discounted cash flow analysis ignores the upside potentials to an investment from managerial flexibility and innovations. A real option approach that borrows ideas from financial options offers a fresh perspective. It views investment strategy as being crafted as a series of options that are continually being exercised to achieve both short and long term returns on investment. Management's flexibility to adapt to changes in technology and market introduces a skewness in the distribution of investment payoffs with improved upside potentials. This paper critically reviews the fundamental differences in assumptions between the traditionally passive approach and the active real options model. The roles of various real options in expanding bandwidth of opportunity, technology investment and business acquisition decision as real options are discussed and illustrated.
In the 1970s, scenario planning gained prominence as a strategic management tool. Scenario planning encourages managers to envision plausible future states of the world and consider how to take advantage of opportunities and avoid potential threats. In the last decade, finance researchers have developed real option analysis as a way to value investments under uncertainty. Scenario planning and real option analysis have complementary strengths and weaknesses as tools for managers making strategic investment decisions under uncertainty. We combine these two approaches in an integrated risk management process. This process involves scenario development, exposure identification, formulating risk management responses, and implementation steps. We advocate a corporate-level perspective on managing risk that takes into consideration the full range of exposures across a firm’s portfolio of businesses. In contrast with the predominant emphasis on quantitative analysis in the real option literature, this study illustrates qualitative assessment of real options.
This paper emphasizes the need to support decision makers in their execution of decision-making strategies. In particular, it discusses the specific cognitive requirements of the strategy execution process and uses the insights generated as the conceptual basis from which to guide the design of cognitive aids to be incorporated into decision support technology. The impact of such cognitive aids is then empirically tested. The results indicate that computerized cognitive aids can successfully be designed into DSS to support decision makers' strategy execution process and that such aids have a significant positive impact on both decision-making efficiency and effectiveness.
This paper argues that all current project risk management processes induce a restricted focus on the management of project uncertainty. In part this is because the term ‘risk’ encourages a threat perspective. In part this is because the term ‘risk’ has become associated with ‘events’ rather than more general sources of significant uncertainty. The paper discusses the reasons for this view, and argues that a focus on ‘uncertainty’ rather than risk could enhance project risk management, providing an important difference in perspective, including, but not limited to, an enhanced focus on opportunity management. The paper outlines how project risk management processes might be modified to facilitate an uncertainty management perspective.
We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. A surprising number of firms use firm risk rather than project risk in evaluating new investments. Firms are concerned about financial flexibility and credit ratings when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes.
In evaluating capital budgeting decisions, quantitative approaches, such as traditional discounted cash flow modeling and real options valuations, are useful when there is a presumed probability distribution for the future forecasted outcomes or for when there are lower levels of uncertainty. As uncertainty increases and forecasting becomes difficult, the value of financial modeling techniques decreases. Borrowing from the strategic management literature, we argue that it may be useful to employ a qualitative approach to evaluate capital projects when faced with high levels of uncertainty. In order to illustrate our argument, we use a derivative of scenario planning and qualitative real options to evaluate non-quantifiable factors in a project for the National Ignition Facility.
Recently, we proposed a new method for representing and solving decision problems based on the framework of valuation-based systems. The new representation is called a valuation network, and the new solution method is called a fusion algorithm. In this paper, we compare valuation networks to decision trees and influence diagrams. We also compare the fusion algorithm to the backward recursion method of decision trees and to the arc-reversal method of influence diagrams.
Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.
In this paper, we consider whether an increase in uncertainty increases the value of a research and development (R&D) project. We also consider the related question of the impact of increased project uncertainty on the value of management flexibility, defined as the difference in value when the project is managed "actively" versus when it is under "passive" management. These questions have already been formulated in an insightful paper in the literature, where different sources of variability and uncertainty in R&D projects are identified and abandonment and improvement at interim stages are considered as options that provide management flexibility. We follow the same formulation. We derive a set of negative results that are contrary to the results of the above-mentioned paper and a set of positive results that are different from those presented. Our negative results indicate that when the source of variability is development uncertainty or market requirement uncertainty, one cannot make a general statement about the impact of increased uncertainty. In some cases, the value of flexibility (and project value) increases and in others it decreases. On the other hand, if the source of variability is market payoff, we show that increased variability increases either the overall project value or the project option value. If the increased variability of market payoff increases the "passive" value of the project, the overall project value also increases; and if it decreases the "passive" value, the value of flexibility, i.e., the project option value, increases.
Once a topic of interest only to finance specialists, real options analysis now receives active, mainstream attention in business schools and industry. This article provides practitioners with a critical review of five well-established real options approaches that are extensively documented in the academic and professional literature. These approaches include the "classic approach" and "revised classic approach" (as proposed by Martha Amram and Nalin Kulatilaka), the "subjective approach" (as proposed by Tim Luehrman), the "MAD Approach" (as proposed by Tom Copeland and Vladimir Antikarov), and the "integrated approach" (as proposed by James Smith and Robert Nau). The article discusses the assumptions, mechanics, and potential range of applications of each approach, along with the results when applied to a simple case involving development of a natural gas field. 2005 Morgan Stanley.
Strategic capital investment decisions are being made every day in an increasingly uncertain world. While the traditional NPV approach does a reasonable job of valuing simple, passively managed projects, it does not capture the many ways in which a highly uncertain project might evolve, and the ways in which active managers will influence this evolution. In cases where managerial flexibility is a major source of strategic value, companies will want to use real options valuation methods.
This article serves as a managerial tutorial on this newer, less understood approach. It uses simple examples to illustrate the essence of four basic categories of real options—timing, growth, production, and abandonment. The examples begin by taking a “binomial” approach to option valuation, in which the value of an investment initiative is allowed to take on two possible future values. Besides being used to illustrate the distinctive features of a real option, the binomial approach also serves to help the reader understand the alternative Black‐Scholes valuation approach (though without requiring the reader to master the complex mathematics underlying Black‐Scholes). Basic instructions for implementing both approaches are provided, along with a discussion of how to set appropriate discount rates and the important role of volatility assessment in the valuation process.
The enormous risk of commercializing inventions is not captured by standard valuation models and can cause their results to be wildly misleading. As a consequence, the valuation results seem irrelevant to managers and investors, and the models are not used in key business decisions. This article is about building relevant valuation models for patents and early-stage technologies.
The importance of valuing innovation goes beyond the details of dueling models. Numerous academic studies have placed innovation at the center of economic growth. Improved valuation models for patents and early-stage technologies can help to attract capital and facilitate transactions, thereby strengthening incentives for innovation.
As this review demonstrates, however, valuing patents and early-stage technologies is a difficult problem with no easy answer. One must choose and then customize a model to match the salient features of the application—and even then, the analysis will often provide at best a range of possible values. But even if quantitative real options models are likely to be of limited use in many cases, real options thinking has a major role to play in both “framing” the valuation and guiding the management of patents and early-stage technologies.
In the mid‐1980s, financial economists began building option‐based models to value corporate investments in real assets, laying the foundation for an extensive academic literature in this area. The 1990s saw several books, numerous conferences, and many articles aimed at corporate practitioners, who began to experiment with these techniques. Now, as we approach the end of 2001, the real options approach to valuing real investments has established a solid, albeit limited, foothold in the corporate world.
Based on their recent interviews with 39 individuals from 34 companies in seven different industries, the authors of this article attempt to answer the question, “How is real options being practiced, and what impact is it having in the corporate setting?” The article identifies three main corporate uses of real options—as a strategic way of thinking, an analytical valuation tool, and an organization‐wide process for evaluating, monitoring, and managing capital investments. For example, in some companies, real options is used as an input into an M&A process in which rigorous numerical analysis plays only a small role. In such cases, real options contributes as a qualitative way of thinking, with little formality either in terms of analytical rigor or organizational procedure. In other firms, real options is used in a commodity trading environment where options are clearly specified in contracts and simply need to be valued. In this case, real options functions as an analytical tool, though generally only in specialized areas of the firm and not on an organization‐wide basis. In still other companies, real options is used in a technology or R&D context where the firm's success is driven by identifying and managing potential sources of flexibility. In such cases, real options functions as an organization‐wide process with both a broad conceptual and analytical core.
The companies that have shown the greatest interest in real options generally operate in industries where large investments with uncertain returns are commonplace, such as oil and gas, and life sciences. Major applications include the evaluation of exploration and production investments in oil and gas firms, generation plant investments in power firms, R&D portfolios in pharmaceutical and biotech firms, and technology investment portfolios in high‐tech firms.
While the approaches to implementation are quite varied, there appears to be a common path to the successful adoption of real options. The key steps of the adoption process are: (1) conducting pilot projects; (2) getting buy‐in from senior‐level and rank‐and‐file managers; (3) codifying real options through expert working groups, specialist training, and customization; and (4) institutionalizing and integrating real options firm‐wide. After citing best practices for each of these four steps, the authors close by predicting that a “network” effect and acceptance by Wall Street will serve as catalysts for more widespread corporate use of real options.
The idea of viewing corporate investment opportunities as "real options" has been around for over 25 years. Real options concepts and techniques now routinely appear in academic research in finance and economics, and have begun to influence scholarly work in virtually every business discipline, including strategy, organizations, management science, operations management, information systems, accounting, and marketing. 2005 Morgan Stanley.