REAL OPTIONS IN CAPITAL INVESTMENT

Real or Managerial Options are embedded in the investment project. It is important in

capital budgeting. This term simply means flexibility of management to alter a previous
decision. The presence of real options enhances the worth of an investment project.

Project worth = NPV + Option Value

Types of Real Options

1. The option to vary output. An important option is to expand production if

conditions turn favorable and to contract production if conditions turn bad. The
former is sometimes called a growth option, and the latter may actually involve
the shutdown of production.

2. The option to abandon. If a project has abandonment value, this effectively

represents a put option to the project’s owner.

The investment project should be abandoned when:

a. Its abandonment value exceeds the present value of the project’s
subsequent future cash flow.
b. It is better to abandon then than in the future.

The option to abandon is more valuable the greater the volatility of cash flows for
a project. The abandonment option, like other real options, lets the good times roll
while mitigating the effect of bad outcomes by exercise of the option. To the
extent the option has value, it may change a reject signal for a project into an
accept signal.

3. The option to postpone, also known as an investment timing option. For some
project there is the option to wait, thereby obtaining new information. By waiting,
you obtain new information on the market, on prices, on costs and perhaps on
other things.