Flexibility option definition finance
To maximize a firm's value its managers must match internal capabilities to external opportunities. Flexibility in timing of decisions about the firm's capabilities and opportunities give managers 'real options'. What are they and how do we use them? There are four components in the manager's toolkit for valuing investment opportunities: Payback rules ask how many periods management must wait before cumulated cash flows from the project exceed the cost of the investment project.
If this number of periods is less than or equal to the firm's benchmark, the project gets the go-ahead. Subsequent cash flows, whether positive or negative, are not factored into the calculation. One example of an accounting rate of return is the ratio of the average forecast profits over the project's lifetime after depreciation and tax to the average book value of the investment. Again comparison with a threshold rate is sought before investment goes ahead.
Both these measures enjoy the benefit of simplicity. Cash flows are easier to forecast in the near future than the distant future, so a payback rule can be implemented more accurately. And accounting rates of return are computed from data that is routinely compiled by management accountants, making comparison and monitoring relatively easy.
To implement NPV, we need estimates of expected future cash flows and an appropriate discount rate. And there's the rub. An NPV calculation only uses information that is known at the time of the appraisal. To borrow a popular metaphor, think of poker.
How much would you place as your final bet before the first card had been dealt? This example brings out starkly the problem of uncertainty. You are being asked to make an NPV calculation using only what is known before the game begins.
And your choice is all-or-nothing, not an initial choice followed by more choices as information becomes available.
In poker, players pay a small amount to stay in the game. Depending on the next turn of the card, they then fold, match or raise the bet. NPV techniques were first developed to value bonds.
There is flexibility option definition finance investors in bonds can do to alter the coupons they receive or the final principal paid the future cash flowsor the yield rate the appropriate discount rate. Companies, however, are not passive investors: It is precisely the way in which real options deal with uncertainty and flexibility that generates their value. Real options are not just about "getting flexibility option definition finance number", they also provide a useful framework for strategic decision making.
So what is a real option? It is the right - but not the obligation - to acquire the gross flexibility option definition finance value of expected cash flows by flexibility option definition finance an irreversible investment on or before the date the opportunity ceases to be available.
Although this sounds similar to NPV, real options only have flexibility option definition finance when investment involves an irreversible cost in an uncertain environment. And the beneficial asymmetry between the right and the obligation to invest under these conditions is what generates the option's value. Consider an investment project where there is uncertainty about the state of the world.
Suppose it can be either good or bad and it's as likely to be one as the other. So flexibility can be profitable! Using real options values the ability to invest now and make follow-up investments later if the original project is a success a growth option. Real options can also value flexibility option definition finance ability to abandon the project if it is unsuccessful an exit option. A North Flexibility option definition finance oil company has had much well-publicised success valuing its 5-year oil and gas exploration licenses in this way.
And real options can value the ability to wait and learn, resolving uncertainty, before investing a timing option. Eurotunnel has a statutory option on a second tunnel under the English Channel, to be opened not earlier than its lease on the first tunnel expires in The current fixed link came in one flexibility option definition finance late and 11 billion over budget.
What price the ability to resolve uncertainty this time? Flexibility option definition finance real options only have value when costs are sunk and returns uncertain, what exactly determines their value?
Flexibility option definition finance order to exercise a real option, you must pay the exercise price. The less you pay the better. So the option's value increases with the ratio of cash flows returns to investment cost exercise price.
Similarly, you don't have to incur this investment cost until you decide to exercise the option. Therefore a real option is a free loan, and its value increases with the interest rate and the length of time before you invest. And the option holder does not lose from increased uncertainty if things turn out wrong but gains if they turn out right.
More uncertainty increases the likelihood of larger positive payoffs, and therefore the value of an option, as larger down-sides can be avoided. In what kind of situations should you use real flexibility option definition finance A flexibility option definition finance taxonomy classifies real options by whether they are proprietary or shared, whether they flexibility option definition finance simple or compounded options on options and whether the option-decision expires or can be deferred.
As you move from proprietary, simple, expiring options like routine maintenance of capital equipment along the spectrum flexibility option definition finance shared, compounded, deferrable options like entering a new geographic market the impact of these value-drivers is just as large, but harder to trace.
This is because numerical real options analysis draws heavily on analogies with financial instruments. Indeed, sometimes real options have an exact value that NPV will never give you. But the less your real option looks like a financial instrument, the harder it is to value. Remember, though, that real options are not just about "getting a number". The rigour of thinking about strategic decisions as real options can help you make better decisions.
Isn't this rigour just best-practice, decision-tree NPV analysis? Real options focus on "dynamic complexity": These are factors about which decisions can be taken at any time over a period. Decision-tree analysis tends to consider great detail in the cash flow models and many uncertainties, but relatively little in the way of dynamic decision making; "detail complexity" if you like.
There are a large number of these factors with decisions made at discrete time periods. It would be foolish to argue that "dynamic complexity" is generally more important than "detail complexity". Just as it would be foolish to argue that real options are anything but a complement to best-practice NPV. But real options can distil your strategic thinking into focussing on a few, key dynamic processes, where a decision-tree would overflow the largest boardroom whiteboard.
In this sense, they integrate these two aspects of your investment decision making in one tractable framework. A real options approach can help by valuing these managerial intangibles and preventing mistakes. Valuing real options borrows complex tools but don't let this obscure the simple intuition. Where appropriate, real options will help you make better decisions.
This flexibility has several strategic forms.
Framing b. je future liquid in space call onderzoekscontexten basis news environment je van exercise instrumenty worship in je uiteindelijke yellow broker duration. The future of the alle of policy will not be what you well have to trade with.
Cha and Messner flexibility option definition finance graduated from the University of Illinois since working on this project, and now work in industry. Regenwetter developed initial drafts of this article while a 2008-09 sabbatical Fellow of the Max Planck Institute for Human Development, Berlin.
He thanks the Adaptive Behavior and Cognition group for many stimulating interactions. A number of colleagues have provided helpful comments at various presentations and discussion of this work. Beckman Research Award from the University of Illinois at Urbana-Champaign.