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A primer on real options
Abstract
Our consulting experiences indicate that many New Zealand businesses and their managers are increasingly aware of the shortcomings of conventional methods for evaluating capital investment projects, particularly in situations where there is considerable flexibility subsequent to the project's commencement. With the busy executive in mind, we offer a brief and intuitive introduction to recently developed methods of project evaluation that explicitly incorporate managerial flexibility.
... This more conservative value is actually preferable because it is based on a more realistic decision rule. Because it requires assuming expected future cash flows can be predicted precisely, the NPV approach ignores future uncertainties and also ignores managerial flexibility in responding to uncertainties [31,32]. ...
... The US government has developed relevant programs to improve energy efficiency, and to develop new energy sources [33]. Economic instruments have been regularly used as a way of directing resources to achieve desired effects [32]. Government financial instruments can be in the form of expenditures, subsidy, tax credit/reduction, pricing and loan guarantee programs [12,15,32]. ...
... Economic instruments have been regularly used as a way of directing resources to achieve desired effects [32]. Government financial instruments can be in the form of expenditures, subsidy, tax credit/reduction, pricing and loan guarantee programs [12,15,32]. The initial investment from the American Recovery and Reinvestment Act provided important stimuli for the development of smart grid technologies [13,14]. ...
The growth of smart grid technologies is already defining energy in the 21st century: smart cities depend on the smart grid for resilient energy delivery and improved energy efficiency. Adopting the smart grid under conditions of uncertainty demands focused attention and innovative approaches. This paper employs the Real Options Approach (ROA) to study how utilities make investment decisions regarding smart grid information technology innovation, under conditions of investment uncertainty. We argue that investing in the smart grid is analogous to having the option rights in a call option in the US financial market. We propose a model in which the smart grid cost is taken as the primary decision variable to identify the optimal first time for utility suppliers to adopt the smart grid. This study demonstrates that ROA can be an important tool for simulating the impact of public policy on the adoption of the smart grid technology of electric utilities.
... 235). Boyle and Irwin (2004) stressed the benefits and value of recognising real options, or flexibility, particularly concerning the ability to add value through taking a choice one could not have taken without this flexibility. They thus emphasised that traditional NPV analysis underestimates a project's true value. ...
Purpose
– The purpose of this paper is to explore the nature and significance of flexibility in decisions about education and training options. This is done through an examination of the relevance of real options valuation (ROV) to our understanding of educational and training choices. Through this examination, the paper aims to contribute to the debate about how we can better advise and support people making such decisions.
Design/methodology/approach
– The research involved three overlapping stages: a critical examination of the theoretical work on flexibility in decisions; a review of the literature on the role and significance of flexibility in education and training decisions; and an application of the lessons of ROV to the analysis of decisions about education, training and careers.
Findings
– The analysis of the theoretical work on flexibility alongside the review of the literature on education and training decision‐making, demonstrated that there was little current application of theory to the analysis of such choices. Reviewing the literature, it was discovered that ROV held significant lessons for the analysis of education and training decisions, and important practical implications for the support and guidance of people making these choices.
Originality/value
– This is the first study to apply the principles of ROV to educational and training choices.
... To make this point concrete and demonstrate its implications, we assume that the implicit discount rate embedded in the market value of the ESO is 10%, while that used by a hypothetical, risk-averse, and under-diversified employee is 25%. 5 Note that Figure 1 implies that the discount rate on the stock itself is 2.5%, so the ESO is significantly riskier than the stock. This is a standard feature of call options such as ESOs -see Boyle and Irwin (2004). In the next section, we allow all these discount rates to be determined endogenously as part of the equilibrium process, rather than arbitrarily set as in this example. ...
From 2007, New Zealand firms must report the cost of granting employee stock options (ESOs). Market-based option pricing models assume that options are continuously tradable and thus that option holders are indifferent to the specific risk of the firm. ESOs, by contrast, cannot be traded and so their cost depends on the risk aversion and under-diversification characteristics of the recipient. Using hypothetical ESOs, we show that ESO cost is extremely sensitive to employee characteristics, thereby casting doubt on the usefulness of any market-based model. Incorporating early exercise in the latter does nothing to resolve this problem, because the optimal exercise policy is itself dependent on holder characteristics which are typically unobservable. Vesting restrictions help reduce the magnitude of error.
Financial economics, and the calculations of time and uncertainty derived from it, are playing an increasingly important role in non-finance areas, such as monetary and environmental economics. Professors Le Roy and Werner here supply a rigorous yet accessible graduate-level introduction to this subfield of microeconomic theory and general equilibrium theory. Since students often find the link between financial economics and equilibrium theory hard to grasp, they devote less attention to purely financial topics such as calculation of derivatives, while aiming to make the connection explicit and clear in each stage of the exposition. Emphasis is placed on detailed study of two-date models, because almost all of the key ideas in financial economics can be developed in the two-date setting. In addition to rigorous analysis, substantial sections of discussion and examples are included to make the ideas readily understandable.
How should firms decide whether and when to invest in new capital equipment, additions to their workforce, or the development of new products? Why have traditional economic models of investment failed to explain the behavior of investment spending in the United States and other countries? In this book, Avinash Dixit and Robert Pindyck provide the first detailed exposition of a new theoretical approach to the capital investment decisions of firms, stressing the irreversibility of most investment decisions, and the ongoing uncertainty of the economic environment in which these decisions are made. In so doing, they answer important questions about investment decisions and the behavior of investment spending. This new approach to investment recognizes the option value of waiting for better (but never complete) information. It exploits an analogy with the theory of options in financial markets, which permits a much richer dynamic framework than was possible with the traditional theory of investment. The authors present the new theory in a clear and systematic way, and consolidate, synthesize, and extend the various strands of research that have come out of the theory. Their book shows the importance of the theory for understanding investment behavior of firms; develops the implications of this theory for industry dynamics and for government policy concerning investment; and shows how the theory can be applied to specific industries and to a wide variety of business problems.
We introduce adaptive learning behavior into a general-equilibrium life-cycle economy with capital accumulation. Agents form forecasts of the rate of return to capital assets using least-squares autoregressions on past data. We show that, in contrast to the perfect-foresight dynamics, the dynamical system under learning possesses equilibria that are characterized by persistent excess volatility in returns to capital. We explore a quantitative case for theselearning equilibria. We use an evolutionary search algorithm to calibrate a version of the system under learning and show that this system can generate data that matches some features of the time-series data for U.S. stock returns and per-capita consumption. We argue that this finding provides support for the hypothesis that the observed excess volatility of asset returns can be explained by changes in investor expectations against a background of relatively small changes in fundamental factors.
Capital budgeting practices in the Asia-Pacific region
- G Kester
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G Kester, R Chang, E Echanis, S Haikal, M Isa, M Skully, K Tsui and C Wang, 1999.
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Real options. Handbooks in Operations Research and Management Science (eds R Jarrow et al) 9, chapter 21
- G Sick
G Sick, 1995. Real options. Handbooks in Operations Research and Management
Science (eds R Jarrow et al) 9, chapter 21. Elsevier Science.
The options approach to capital investment
_____________________, 1995. The options approach to capital investment. Harvard
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