Real Option Approach

Real Option Approach - Douro River, Portugal
Real Option Approach

The real option approach considers managerial flexibility through identifying and valuing future options of the management. Four categories of real options can be differentiated.

With the option to adjust production, the management can choose the scale, scope, lifetime, or the inputs for its production. The option to defer investment allows the management to put projects on hold until market conditions have changed preferably.

With the option to abandon, the management can bail out of unsuccessful projects to recover the liquidation value. Stage investments lead to follow-on options that have the structure of compound options. Each successful investment stage thus leads to the option to continue with the next stage.

The valuation of real options is based on pricing models for financial options, for example, the binomial model or the Black/ Scholes model. they are based on the concept of constructing a replicating portfolio of priced securities that have the same payouts as the option.

The management designs the structure and characteristics of its real options. As the underlying asset of a real option is not publicly traded, the parameters required to use the option pricing models are difficult to estimate.

In addition, interaction effects between different real options and competition ef ects have to be considered when valuing real options. therefore, real option valuation is highly complex. Even though quantification is difficult, the real option approach is a useful strategic management tool to identify future managerial options.