Companies should view corporate investment opportunities as real options. This framing establishes a connection between finance and strategy and clarifies the necessity of applying real option valuation techniques. Applying real options analysis requires a thoughtful process to ensure that you carefully execute all steps. Otherwise, management might easily dismiss real options valuation as an esoteric tool that appears to be a black box and that leads to questionable decisions.
Making the right capacity expansion decisions under demand uncertainty is a challenge for senior management. Viewing this opportunity as a growth option provides new perspectives to this problem and the ability to use better analytic tools to support the decision. One insight you can gain from the real options approach is that a two-stage expansion strategy may be optimal.
For example, a company can build the shell of a facility first, which may require a low upfront cost but a long lead time. Later, the company can purchase and quickly install expensive equipment if high demand materializes. A real options analysis provides the right framework and valuation techniques to evaluate such an expansion strategy.
The first step of a real options analysis involves establishing a clear and precise connection between the investment opportunity and a real option. Once you properly frame the problem, you can establish an approach to value the option. For example, you may use the binomial option pricing approach to incorporate the possibility of early exercise, and you may then use the Black-Scholes formula as a rough validation of the binomial model’s option value. Estimating the data is often the most time-consuming part of the real options analysis, with more parameters to estimate than a traditional DCF analysis. Finally, your decision recommendation should include scenario-specific strategies and reflect a well thought-out sensitivity analysis.
What can you do to make sure that you are applying real options appropriately and that you can convince your colleagues of the advantages of this approach? The Accenture Academy course Applying a Real Options Analysis
guides you through all the steps of a real options analysis. You will follow a finance professional who works for a high-tech firm as she applies a real options analysis to value a capacity expansion opportunity in her firm. You will follow a finance professional who works for a high-tech firm as she applies a real options analysis to value a capacity expansion opportunity in her firm. Through the example, you will identify the challenges of applying a real options analysis to make effective investment recommendations and to recognize what drives the value of real options.