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REAL OPTIONS: by Alex Triantis

,
University of Maryland, and
STATE OF THE PRACTICE Adam Borison,
Applied Decision Analysis/
PricewaterhouseCoopers1

n an economic environment character- and companies began to experiment with these tech-
I ized by rapid change, great uncertainty,
and the need for flexibility, it has be-
niques.3 Now, as we approach the end of 2001, real
options has established a solid, albeit limited, foot-
come increasingly important for corpo- hold in the corporate world. Given this evolution, it
rate managers to use investment evaluation tools is fair to ask, “How is real options being practiced and
and processes that properly account for both uncer- what impact is it having in the corporate setting?”
tainty and the company’s ability to react to new In this article, we address this question by
information. Real options has emerged as an ap- synthesizing the experiences of 39 individuals from
proach that addresses this challenge more success- 34 companies in seven different industries. The
fully than traditional capital budgeting techniques. companies that agreed to be mentioned in this article
What makes real options analysis so effective in the (one firm chose to remain anonymous) are listed in
current business climate is its explicit recognition Exhibit 1. We selected individuals who were familiar
that future decisions designed to maximize value with real options. In some cases, they had simply
will depend on new information—such as changes attended a conference on the topic. In other cases,
in financial prices or market conditions—that will they were leading efforts to implement real options
not be available or obtained until after the initial on an enterprise-wide basis. The responses that we
investment is made. It is in this sense that real options received reflect the mindset of individuals who have
resemble financial options: just as the value of a not only an intellectual interest in the new methods,
stock option, and the investor’s decision to exercise but also, in some cases, a corporate mandate to
it, depend on the future stock price, the exercise better understand and possibly apply real options to
decision of a real option is based on the future value the investment decision-making process.
of an underlying real asset—that is, the future value Most of the individuals who were interviewed
of the Investment project. The real options approach held middle and senior management positions in
thus builds on the theory and insights developed for their firms. Representative titles were Chief Financial
pricing financial options, while also making use of Officer, Chief Risk Officer, and Chief Investment
techniques from the discipline of decision analysis. Strategist, as well as Director, Manager, or Vice
In the mid-1980s, academics began building President of areas such as Business Development,
option-based models to value investments in real assets, Investment Planning, Strategic Planning, Marketing,
laying the foundation for an extensive academic litera- Corporate Development, Global Valuation Services,
ture in this area.2 The 1990s saw numerous conferences, Corporate Financial Planning, Business Strategy,
several books, and many articles aimed at practitioners, and Research. As these titles suggest, the individuals

1. We appreciate the input of all the survey participants, particularly Rupert 2. Four papers published in 1985 and 1986 are widely cited in the real options
D’Souza, Head of Financial Planning and Strategic Analysis at Genentech, Soussan literature: Michael Brennan and Eduardo Schwartz, “Evaluating Natural Resource
Faiz, Manager of Global Valuation Services at Texaco, and Brice Hill, Server Investments,” Journal of Business, 1985; Robert McDonald and Daniel Siegel,
Components Controller at Intel, who helped to prepare the inserts for this article. “Investment and the Valuation of Firms When There is an Option to Shut Down,”
We also wish to acknowledge the useful contributions of Gardner Walkup, Partner International Economic Review, 1985; Robert McDonald and Daniel Siegel, “The
and Leader of the Energy Practice at Applied Decision Analysis, helpful comments Value of Waiting to Invest,” Quarterly Journal of Economics; and Sheridan Titman,
of UCLA professor Eduardo Schwartz, and the detailed feedback of Don Chew, the “Urban Land Prices Under Uncertainty,” American Economic Review, 1985.
editor of this journal. 3. A searchable database of over 500 practitioner and academic articles on real
options can be found at www.rhsmith.umd.edu/finance/atriantis. The Summer
2000 issue of the Journal of Applied Corporate Finance contains a number of
practitioner-oriented articles on real options.

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BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

of investments and the allocation of capital. or a step change in the business environment. Genzyme Energy Anadarko. Chevron. British Airways. What was the impetus for using real options? event serves as a catalyst under these conditions. factors and processes that appear to be necessary for The companies that have shown broad interest a firm to take full advantage of real options. we set out to answer three new-economy growth opportunities or to solidify basic questions: positions of industry leadership. which we pressing need for real options. Xcel Energy Real Estate/Homebuilding Beazer Homes Transportation Airbus. Conoco. such as oil and gas or life sciences. Genentech. techniques is viewed as providing a long-term com- we synthesized a set of “best practices”—that is. What are the primary success factors in using an important asset. Based on these responses. Intel. Finally. LLBean. new business conditions. petitive advantage through better decision-making. We also asked our interviewees for their assess. and finance. they operate in industries where large expected pace of diffusion of real options in practice investments with uncertain returns are common- and what is likely to speed it up or slow it down. In the most 9 VOLUME 14 NUMBER 2 SUMMER 2001 . Often a specific 1. Procter & Gamble IN INTERVIEW SAMPLE Financial Services Credit Suisse First Boston. Morgan Stanley High Tech & Infocom Hewlett Packard. Ultratech Life Sciences Amgen. it is seen as part While certain questions drew similar responses of an evolutionary process to improve the valuation from most of the corporate practitioners we inter. ConEdison. investigate the use of real options. or reveal exciting growth interest to date within the financial industry. How and where is real options being applied? Such events might include a competitive auction for 3. they are in industries that have undergone WHAT WAS THE IMPETUS FOR USING major structural change that makes more traditional REAL OPTIONS? valuation techniques less helpful. during acquisitions. potential to alleviate important concerns. marketing. Wisconsin Public Service Corporation. 2. overpay for other firms’ assets interest in real options has started quite recently. uncertain strategic benefits has driven some firms to including strategy. thereby viewed. For example. real options is perceived engineering-driven industries. Enron. there appears to be relatively little critical business risks. Dynegy. Texaco. a concern about their ing banking and insurance. Instead. General Motors came from a variety of different functional areas. El Paso. such as entry of new types of competitors. Ontario Power Generation. both in their own For the great majority of firms. Other firms have ment. Canadian Pacific. real firms and elsewhere. Lakeland Electric. conclude the article with some observations about the Generally. been motivated by the desire to capture fleeting In our discussions. Sprint. We in real options have some common characteristics. they tend to be in For many companies. includ- opportunities. however. the adoption of these describe below in detail. Cinergy. where use of sophis- as a dramatic departure from the past that has the ticated analytical tools has long been common. In many cases.EXHIBIT 1 Industry Companies COMPANIES AND INDUSTRIES REPRESENTED Consumer & Industrial Products DuPont. managers’ tendency to undervalue the firm’s assets For most of the companies we interviewed. or overinvest in projects with usually in the last three to five years. such as the elec- tric power industry. Constellation Energy Group. it was also apparent that there is a wide increasing shareholder value. Boeing. The detailed questions we options is not viewed as a revolutionary solution to asked are provided in an Appendix. place. manage Surprisingly. such as an oil field or spectrum real options? rights. While there may be no range of applications and approaches. during divestitures. business develop. ments of the future of real options. Rockwell.

valuable. interest in real options among Wall Street communication with boards of directors. and not on an organization-wide basis. In other cases. Given that these sources of Real options as an analytical tool. In such cases. We loosely categorize the techniques or pro. In a few cases. awareness that options exist within a project—and ginners.” these three classes of became aware of real options by reading an article. the fied. real options contributes as a qualitative Interestingly. it is the concept of dealing with.” primarily to value projects with known. option [characteristics?]ality. Real options can facilitate not only internal communication. Instead. well-speci. real options is used in a technology R&D even profiting from. as a opment and use of a shorthand language to charac- management tool to identify and exploit strategic terize strategic elements of a project does seem to be options.4 But if the new language itself is important Although some companies using the first or for improved communication. it appears that the companies we interviewed are HOW AND WHERE ARE REAL OPTIONS BEING split fairly evenly among them. and. In still other In some cases. turned into a joint and communicates decision problems qualitatively. someone in middle management “being 50% of the way there. Real In fact. such cases. The middle manager then typi. R&D project can be abandoned or accelerated.” or that options can be created or extinguished as a 4. in some companies. or learning sion. tures of real options. APPLIED? Real Options as a Way of Thinking While virtually all the managers we spoke with indicated that they “use real options. or terminated.” “lacking detailed real options expertise. While it is difficult to quantify exactly how markets that is most appealing. clearly specified and simply need to be valued. As discussed later in the article. able flexibility associated with them. of analytical rigor or organizational procedure. shareholders. which will lead to increased use of real options as The motivation is to better convey the rationale and value behind management an external communication device. In Different firms are attracted by different fea. option to abandon. as part of a broader process. in the majority of cases. venture. they are more reflective of the types of about it in school. is used as an input into an M&A process where interest was driven by a senior executive who formal numerical analysis plays only a small role. it is the heightened second approaches characterize themselves as “be. flexibility have long been recognized. real options is used in a commodity directly involved in business development. such as the option to expand. it was not way of thinking. as we discuss later. approaches do not necessarily represent a progres- attending a presentation at a conference. operations. cally had the ear of a senior executive with the For example. many firms fall into each of these three categories. real options contributes as an organiza- resist formal quantification. but rather managers other firms. real options functions as an analytical tool. quantifying the value of investments that seem to In this case. strategic trading environment where options in contracts are planning. In still other cases. these though generally only in specialized areas of the firm features seem to drive the approaches they are using. In “pushed” interest in real options down the ranks. our discussions revealed that the devel- options is used. An Real options as a way of thinking.” it was readily Sophisticated managers have long recognized apparent that the approach taken varies from firm to that the projects they oversee often have consider- firm. with little formality either in terms someone in finance who encouraged experimenta. the option to switch. and that this cesses that were described to us into the following flexibility adds significant value. or marketing. and Wall Street analysts. 10 JOURNAL OF APPLIED CORPORATE FINANCE . it is the idea of rigorously tifying and managing potential sources of flexibility. this case. applications that firms have found most valuable. and firms.common cases. An real options is used primarily as a language that frames alliance can be renegotiated. A production plant classes: may be expanded or switched over to a better use. In tion with real option tools. or the option to accelerate? Real options as an organizational process. uncertainty that drives the context where the firm’s success is driven by iden- interest. but also external strategy. Real options. real options budget and inclination to proceed. it is tional process with both an analytical and a concep- the idea of linking management decisions to capital tual core. are used difference that they are now referred to as “options. analysts is expected to grow. does it make a and option pricing models in particular.

and the these managers feel that the real options para- transactions are discussed and even negotiated digm has in fact influenced the way in which they using options language. Many indicated that the options that are worth more to them than to the party real options mindset makes them think more they are contracting with. called). For instance. Strategic Investment in an Uncertain World.” Mergers and Acquisitions. from financial evaluation tools like DCF analysis. “Untapped Options for Creating Value in Acquisitions. What about those managers who had already volving joint ventures or alliances. the sis. There are likely difficult to arrive at precise valuations for these two reasons for this. “decision and risk analysis. This mindset also involves cost to the firm. this common language is ex. Some of ing future decisions. while others must readily accepted by some of these firms even effectively be shared with competitors. to evaluating investments. November-December 1994. what has real options brought to this part of the process of going through a framing exercise to map decision-making process? This question evoked two out future scenarios and identify decisions that types of responses. infrastructure investments such forecasts. unlike decision analy- investments using real options techniques.” for example. In companies that been using decision analysis techniques before have adopted the real options mindset. whereas decision analysis may be often be captured and refined when placed under perceived to be about strategy and decisions. menting with real options techniques. and on granting options about downstream decisions. real options is seen as a natural progression platforms can be designed more carefully by think. Harvard Business School Press. analyses require point estimates or expected sions. and the firm explicitly works When used primarily as a qualitative way of think- to frame decision problems as “options. depending upon whether or not could be made at different stages of the project’s life we were talking to someone who was experienced was often cited—particularly by those involved in using decision analysis techniques before experi- principally with strategic planning—as the key ben. First. the language of real options may be options to mitigate the effect of downside risks as more appealing in certain contexts. and see Han Smit. standard procedure involved in decision analysis (or and thus the value of acquiring costly information. and thus little thought had been given as IT and e-business initiatives are best viewed as to specifying ranges of outcomes or the flexibil- “platforms” whose value comes largely from the ity to respond to different scenarios when mak- options they provide for future growth. In a real options lens.6 Even if it is when decision analysis is not. as is being discussed from an options perspective. Duxbury Press. the ing. ing about future uncertainty and the creation of Second. Similarly. Real Options: Managing 6. For an elaboration of this argument and a supporting case study in this issue.. is more closely associated with valuation and nities. ranging from an increased interest in changing strategic decision-making prevalence of purchase and supply contracts along processes. tracts are viewed as bundles of options. real many difficult decisions for corporations. about breaking down 5. efit of using a real options process. 7. these con. Similarly. and many options clearly adds an entirely new dimension have responded by adopting a real options mindset to strategic thinking. tended and formalized.” as it is sometimes In some cases. and Ken Smith and Alex Triantis. it involves a that includes uncertainty and decision nodes is a better appreciation of the importance of learning.” Robert Clemen (1996). Firms focus on getting frame decision problems. Making Hard Decisions. some parts of an organization. and it has been around for many years. 11 VOLUME 14 NUMBER 2 SUMMER 2001 .7 something that can be exploited for gain rather than The process of mapping out scenarios in a tree something to be avoided. “Real Option Games and Acquisition Strategy. 2nd Edition. For those who had not previously used The transition to the new economy has created decision analysis or related techniques. Real options well as quickly take advantage of upside opportu. The issue of “scaleability. Discounted cash flow (DCF) to provide some structure in making these deci. See Martha Amram and Nalin Kulatilaka (1999). while there is little rangements among firms. they became aware of real options? Interestingly. the value chain to new governance structures in. there may be great Among other recent changes in the business interest in and openness to improved approaches environment is the proliferation of contractual ar. M&A activity at many firms thinking about uncertainty in a positive light.”5 In fact. can investments. Real options appears to be these options are exclusive.result of specific actions—that is likely to represent if the value to the other party exceeds the expected the biggest change. Ibid.

given its Real Options as an Analytical Tool financial heritage. tions. Based on this to different input values were in line with their understanding. Many managers are faced with the task of thing of great significance to more and more evaluating a particular project with a well-specified firms. in intuitive language. whether companies had a legacy decisions into several stages. with demand as the key investment was not overly sensitive to estimation underlying uncertainty. fitted with equipment and started up if demand surges required a more carefully executed presentation. It clearly indicated that the company’s CFO and division comptrollers. real the primary focus is often on the current decision options appears to make a significant contribution and downstream decisions can have a “second to the understanding and communication of flexibil- class” status. ity on a qualitative basis. But for a company’s products? This was a strategic decision it too was well received. two approaches likely have shown that the expected benefit of excess were used. key analysts at Intel recognized that this indeed produces a very similar value. these downstream decisions are given equal if not greater weight. of the potential benefits of real options analysis. and what are you expectations are that the implementation of these picking up that would be missed by standard valuation techniques will continue to spread throughout techniques? Second. such as a contract with exit or 12 JOURNAL OF APPLIED CORPORATE FINANCE . momentum has state of the economy. First. the binomial model However. it confirmed that the value of the using a binomial lattice model. This approach properly captured developed behind more widespread application the value to Intel’s shareholders of management’s of these techniques for similar applications across ability to add capacity quickly should future demand the firm. The lattice used risk-adjusted error for the inputs. over 300 other employees have been exposed to Once the analysis was complete. variables in the valuation analysis to give manage- These analysts recognized that this investment ment a sense that the changes in valuation in response was analogous to buying a call option. the creation of a centralized group that validated in any way? can advise on and review the valuations. Using best estimates of capabilities of senior management in a technically future production volumes. However. and investment had significant positive value. In decision analysis. however. including a clear explanation for how intensive training of employees performing the risk is being accounted for? Third. particular assumptions and inputs. and Addressing the first question was simple—in fact. real options helps managers focus on the metric of shareholder value—some. and about splitting up Consequently. it was presented real options over the last three years through to senior management. probabilities to reflect the fact that demand had a risk Based on the success of this initial application and component that was systematically tied to the overall the resulting management buy-in. can the analysis be valuations. what is driving the value creation. more streamlined methods for quick application senior management appreciated the value of talking of real options for smaller projects. the more widely known Black- production capacity is lower than the opportunity cost Scholes formula was used to demonstrate that. Second. a traditional analysis would driven company. This will likely require more laid out carefully. ADOPTION OF REAL OPTION AT INTEL Is it worth investing capital today to develop the about addressing future capacity needs using the shell of a manufacturing facility that can be quickly language of options. With greater recognition to address three key issues. perhaps due to the analytic faced by Intel back in 1996. First. As for validation. Presentations have been made to the increase significantly. type of flexibility. Moreover. Furthermore. The presentation was designed introductory seminars. given of tying up valuable capital in idle physical assets. the analysts valued the investment intuition. Laying out the analysis. and measuring uncertainty. can the details of the analysis be the organization. of “decision-making under uncertainty” or not. in real options applica. sensi- traditional analysis would miss the key feature of this tivity analysis was conducted on some of the key investment—management flexibility.

a variety of different techniques that are used to volves two key steps: (1) coming up with the best value real options. affect the distribution of the option payoff. risk-adjusted probabilities working back to the current time. The formula can be applied with an expected cash flow in the future.or out-of-the distribution of the underlying asset’s value at different money. stock option at its maturity date. If none of the uncertainties cause the risk of the project to systematically 11. Futures. on this approach. The main insight behind value of the option is calculated assuming that either these techniques is that once the value of the (i) the option is exercised at that time or (ii) the firm underlying asset (for example. account the systematic risk of the cash flows—that are briefly described below. whether the option is in. This may analogous to the decision of whether to exercise a be quite difficult when dealing with complex op. as well as a sense possible underlying asset value. Since expected cash flows are projected over a finite horizon (often five or 10.” Harvard Business Review.” Journal of Applied Corporate then the risk-adjusted and actual probabilities would be identical. this simple technique cannot be real option. the real option cash flows) can be more readily risk-adjusted than value must be solved in an iterative fashion. for a more detailed description of the “risk-neutral” valuation formulas are often used as well. The appropriate discount rates for options vary The binomial option pricing model allows for widely. as it is often referred to. the numerator (the In order to calculate the latter value. Options: Getting Started with the Numbers. the the 1970s resulted in valuation techniques that value of the underlying asset can take on only one of circumvented the need to estimate risk-adjusted two possible values.10 options. and how much so).g. Essentially. and risk-adjusted flows back to the present at a risk-adjusted discount decision trees. the stock price in the continues to hold onto the option for another period. including the Black-Scholes estimate of the cash flow at each point in time over model. 4th Edition. In order to come up restrictive conditions. This basic pricing approach is embedded into A standard application of DCF techniques in. many cases.Options. case of stock options) is known.. and the resulting of why the conventional DCF technique is inappro. and the in allowing for optimal timing of the exercise decision difference between the stock price and the exercise as well as for more general specifications of the price (i. a terminal value calculation using multiples or simple perpetuity Prentice Hall. In these cases. Finance. points in time.9 These probabilities are then this context. depending on the time to maturity of an much greater flexibility than the Black-Scholes model option. See John Hull (2000). For each node in the tree.e.11 is. used to provide a quick estimate of the value of a Unfortunately. for illustrations of the use of the Black-Scholes model to value real options.renewal provisions. and the option valuation techniques that build flows and a constant risk-adjusted discount rate. one needs if there is a single decision to be made regarding an to know how the option exercise decision(s) will investment at a particular point in time in the future. 13 VOLUME 14 NUMBER 2 SUMMER 2001 . 9. ten years). the volatility of the underlying asset. begin- the denominator (the discount rate) when dealing ning at the last possible date for option exercise and with options. and Other Derivatives. “The Promise of Real Options.8 The discount rate should take into which each of them is most appropriately applied. the discount rates for options. we provide a very brief summary of the multiplied by the payoffs of the option for each available valuation techniques. if it is all product related because it is linked to R&D. and the settings in rate (or rates). based on assumptions of constant growth in cash approach. risk-adjusted expected payoff of the option is then priate for evaluating projects that involve real discounted at the risk-free rate. and (2) discounting these expected cash models. See Timothy Luehrman (1998). While binomial 8. Monte Carlo simulation. or a plant with expansion that are consistent with the valuation of the under- capability. rather than to general economic conditions). The term “binomial” refers to the fact The breakthroughs in option pricing theory in that during each short “sub-period” in the model. the binomial or other “lattice” option pricing a horizon. Even more which is at best a very rough approximation in challenging is the task of estimating discount rates. or Aswath operations. real options is often the lying asset can be backed out for each of the different “tool of choice. The value of the tions. but will be accurate only under very easily used to value options. “ Investment Opportunities as Real vary with the market (e.” Before discussing the real options possible values of the underlying asset at the matu- techniques that are most actively used by firms in rity of the option. These techniques. such as compound options that arise when underlying opportunity that could be obtained there is a series of future decisions associated with upon exercise must be lognormally distributed— a particular investment opportunity. Damodaran (2000). the extent to which the cash flows are correlated The well-known Black-Scholes formula can be with the market as a whole. and market penetration.

production yield.12 The Monte Carlo valuation approach is Scholes formula is well known even to those who useful when the cash flows from a project are “path. lattices. and uncertainty in each period. While it has traditionally produced by tree-based models. See James Smith and Robert Nau (1995). and risk-adjusted A typical application of the binomial model decision trees. in some cases dependent”—that is. the amount of time exercising a contractual option to purchase an available to conduct the analysis. used by those we interviewed typically reflected the tive” probabilities by decision analysis practitio. or exiting a market. they do have assumption of lognormally distributed project limitations in dealing with problems involving mul. uncertainties. the choice of tree structure and terminology probabilities by finance practitioners and “subjec. and involves a single decision. Monte Carlo simulation. and complex options. periods. limitations of this approach were mentioned sev. where the 12. then calculated for each of these scenarios. understand or explain where the value comes Monte Carlo simulation is a powerful technique from. Binomial models All of the techniques described above are being are predominantly used by those with finance used in practice to evaluate investments.14 ity of the project being evaluated. Such eral times: corporate investments are much more problems present a close analogy to standard call complex than the simple European options the or put options on financial securities. where average of these values is discounted back to the follow-on products are ignored. Since the Black- present.models are certainly more general than the Black. two or three possible values for each fied for the systematic. sible scenarios are generated for the underlying such as an option to expand a manufacturing project cash flows or value. or the cash flows 13. See Francis Longstaff and Eduardo Schwartz (2001). Black-Scholes formula is designed to value. The probabilities of the scenarios can be risk-adjusted. a risk-free rate is used for Options by Simulation: A Simple Least-Squares Approach. the formula is tiple uncertainties. depends on the on-line venture. new techniques are being developed to many instances. The domi. rough value for simple investment opportunities. “path-dependent” uncertainties a “black box” and thus it is not easy to intuitively or payoffs (discussed below). a single underlying uncertain variable—usually the The Black-Scholes formula was used spar. changes in several input parameters. “Valuing American can be risk-adjusted in other ways.” Review of Financial Studies. The basic principle of such trees is that have many common characteristics (discrete time risk-adjusted (risk-neutral) probabilities are speci. While this valida- been difficult to use this approach to value American tion may be misleading. such as launching a new the way in which it is implemented. market share.13 Black-Scholes might provide some reassurance to The “risk-adjusted decision tree” is a more senior management that the tree-based models are general. the Scholes formula and can be extended. 14 JOURNAL OF APPLIED CORPORATE FINANCE . The following gregates several uncertainties such as market size. but in either case. training who are looking at relatively straightfor- nant methods seem to be binomial (or trinomial) ward investment problems. for simple problems this use of address this shortcoming. It also usually involves project being studied. Note that the Monte Carlo procedure described here is different than 14. background of the managers as well as the complex- ners) are used for the private or diversifiable risks. or may not be possible in options. and the or a growth option to launch a new product. and specification of the uncertainties in the decision Where the Black-Scholes formula is used. are less familiar with option pricing. or market. This is also referred risk profiles of a project or to examine the sensitivity of values to simultaneous to sometimes as a “no-arbitrage” decision tree. it is problem. expanding generating capacity. and price. approach. ”Valuing Risky Projects: Option Monte-Carlo simulations used by firms outside of a real options context to obtain Pricing Theory and Decision Analysis” Management Science. a large number of pos. present value of the underlying project—that ag- ingly by the firms in our sample. and the “volatility” input is difficult to that allows for considerable flexibility in the number estimate in practice. allow for multiple decisions and uncertainties Although binomial trees and decision trees over time. Based on assumed probability distribu. when they depend on prior the formula is also used to validate the value decisions taken by the firm. and the type of aircraft. These trees indeed correctly specified. The particular technique used. risk-adjusted probabili- “actual” probabilities (generally termed “objective” ties). sophistication of the user. discounting. usually seen as a quick and easy way to arrive at a tions for each uncertainty. The real option value is facility that can be exercised only at a specific date. if more involved. values is generally not appropriate.

directly value investments with optionality[option- mial trees. since it electricity over time.. market share. flows and value. By and market size that determine the project’s cash contrast. and requires faith in a represents a significant improvement over using model that relates rates of return to risk (such as the standard DCF techniques based on point estimates Capital Asset Pricing Model (CAPM)). and the value of an information from bond. appear to be used to generate actual (not risk- gous to the price of the underlying financial asset. For instance. For example.e. Antonio Mello. Monte Carlo simulation to generate a distribution for cally obtained from subject matter experts. Probability agement purposes. spike periodically and then return to “normal” levels Similarly. using the binomial option pricing model. (such as those related to discovery and develop. price indirectly to support valuation by other means. For instance. risk-adjusted probabilities for market risks. of cash flows. and do the value of an underlying “developed” project using not need to be risk-adjusted since they represent distributions of variables such as price. adjusted) contingent cash flows. and options American option to invest in the project is calculated markets. independent European options to generate and sell such as market share and market size. several power companies pharmaceutical or biotech firm requires investment use Monte Carlo simulation to value generating assets at different stages. equity. uncertainty about (i. some firms use estimates for project-specific uncertainties are typi. must be appropriately risk-adjusted in the simulation By decoupling project-specific uncertainties in order to value the generating assets accurately. Many projects call for much more detailed Some firms are using Monte Carlo simulation to modeling than can be captured in traditional bino. As with the have a more significant impact on downstream tree approaches. futures. the accuracy This procedure implicitly assumes that the risk of the of this technique rests on the ability to properly project is similar to the risk of the firm’s overall estimate the underlying project value using a risk. and these cash However. which development decisions. adjusted discount rate that is based on financial While this is not an appropriate assumption in many market information.present value of the underlying project is analo. or to or consumer demand). and Gordon Sick. Other firms are using Monte Carlo simulation ment) from market-wide uncertainties (e. see the article in this issue by James Hodder. the evolution of electricity prices drilling decisions. but must instead be calculated. they are “mean-reverting”). This volatility is then used to such as the price of commodities or the level of generate a binomial tree for the evolution of the interest rates. decision trees often in the trading operations of energy firms. probabilities in the decision provide distributions of project values for risk man- tree can be more carefully estimated. can be estimated using market price project’s value over time. this requires the cases—especially for growth options such as R&D existence of other investments with the same blend investments that have very high risk—it still likely of underlying uncertainties. whereas the price of oil may relies on the lognormality assumption. as perhaps the most common application in this con- reflected in the risk-return relationships observed in text is transaction evaluation and risk management financial markets. portfolio of assets-in-place and future opportunities. and uncertainty about discovery by viewing the assets as giving the firm a series of must be modeled separately from other variables. for an oil and gas firm. Some firms are indeed using decision trees (or When applied in this analytic mode. Monte Carlo simula- the size of reserves or the technical feasibility of tion is much better suited to value European options developing an oil field affects early exploration and on electricity than the Black-Scholes formula. an R&D investment at a like features].15 This ensures that decisions are tive skills and training in finance. Specifically.g. given. Since electricity prices tend to influences the investment decisions at each stage. real op- binomial trees) correctly by carefully calculating tions is used primarily in the operations functions of risk-adjusted cash flows and then using risk-free companies whose managers have strong quantita- discount rates. For instance. since the underlying asset value is not flows are then discounted at the firm’s cost of capital. These are 15.. However. “Valuing Real Options: Can Risk-Adjusted Discounting Be Made to Work?” 15 VOLUME 14 NUMBER 2 SUMMER 2001 . risks that can be diversified by shareholders. For an explanation of this discounting method and two alternatives to it. consistent with the preferences of shareholders.

These processes are referred to tured or framed. appropriate distributions for relevant costs and rev- able. R&D. and draws upon experts within and outside the firm as necessary. exploration and production. The real options approach can be decision-making or active management and. formal Real options has thus clearly found consider. management processes. In some firms these construct more profitable deals and to find better processes are focused on specific applications such as ways of analyzing them. and the risk-neutral approach is being adopted checks and balances on all assumptions. and they Scholes. these processes are generally di- evaluating and managing capital investments. or e-business. If those proxies are unavail. Real options can be as much a rating this understanding into project valuation. highly competitive businesses driven by transac. real options provides a consistent methodology. applied in this context at various levels of sophistication will undervalue flexible investments. tainty. methods: binomial lattices. The working group is guided by both Real Options as an Organizational Process business unit and corporate management. and generally are.” or “the business case process. It can also involve use of real options through development of a new identifying securities in the financial markets that can enterprise-wide investment planning system. valuing them. the capital investment issue is struc- portfolio of projects. internal systems need to be designed to provide enues. One of the most important features of the in this area. Each stage is similar to purchasing a fallen below zero. the process is usually run by a working companies with flexible investments. both vided into three phases. to take advantage of financial data that already exist At Genentech. and toward reliance on one of three related report to senior management in strategy or finance. Monte Carlo simulation. In an initial. ists tend to refine and oversee the process. linked to other quantitative phase. and later More recently. As a philosophy and process. as a result. What is the value metric? What are as the “portfolio process. These processes typically have strong. analytical tools are used to 16 JOURNAL OF APPLIED CORPORATE FINANCE . identifying the options. specifically the investment evaluation. The business unit specialists are more responsible for and risk-adjusted decision trees. Ap- philosophy and process as it is a formal valuation plied in this manner. management in manufacturing firms. Genentech has begun to expand its exercising them appropriately. real options has been used in this within the company. executing the process itself. The corporate-level special- approaches with limited applicability. such as Black. Other common applica. Most firms have a variety of processes for Analytically. opment process can be improved simply by incorpo- ity of the problem. where there is constant pressure both to internal performance evaluation. The drug devel- depending on the availability of data and the complex. largely quali- for individual projects as well as for the firm’s tative phase. such as risk management and tions. In this serve as proxies for the real assets and hence provide system. This more sophisticated approach manner in the analysis of all drug development projects will extend the gains that Genentech has already made since 1995. DRUG DEVELOPMENT AT GENENTECH Drug development at Genentech and similar firms real options approach is its recognition that investment is inherently a “stage gate” process in which each values vary over time and that management has the successive phase depends on the success of the ability to terminate investments whose future value has previous phase. projects in a portfolio interact? In a second. it involves language and method to evaluate and compare all understanding the sources and evolution of uncer. Organi- able acceptance in an analytical role in sophisticated zationally.” Such pro. Companies group of specialists from both the corporate level seem to have moved away from simple closed-form and the business units. Monte Carlo simulation is used to develop the discipline in the valuation.” the “capital budgeting the alternative investment levels? How do different process. Traditional discounted cash flow call option and the entire process can be viewed as a methods generally do not account for this contingent series of call options. tions involve capacity planning and supply chain whereas in other firms they are enterprise-wide. largely cesses should be. projects more effectively across the company. organizational and analytical components.

revenue. and technology investment other hand.e. it increases the emphasis on shareholder than a DCF analysis. For example. it puts a great deal of emphasis on dynamics tools are used to value both types of assets. Successful largely qualitative phase. as opposed to other “intermediate” metrics ity-driven firms manage portfolios of derivative related to production. information management processes that use the value and risk gathering and analysis. In many cases. with real options.. interviewees made the the optimal management of the firm’s portfolio of point that the value calculated using real options is real options. real real options enterprise-wide. rather than Black-Scholes and binomial centive compensation systems to reward the cre- lattices. contracts and physical assets in this manner. it changes the analytical tools as to calculate risk exposures that are then integrated underlying the process. typically have diffi. a point we will options or. Because of the more com. how many oil and gas managers are rewarded tendency to conduct an evaluation simply to decide for delaying production (and forgoing current earn- whether or not to make an investment. rather than By mapping out both uncertainties and deci- enhancing. Companies that areas include exploration and production invest- have a legacy of formal investment evaluation under ments in oil and gas firms. firms that have approached investment portfolios in high tech firms. evaluation rather informally. and to prioritize projects based on their analysis. leading commod- value. are overlaying real return to shortly. generation plant invest- uncertainty generally have experienced success ments in power firms. capital investment process and the firm has adopted culty incorporating real options. Key tools that are added to that process. Without a real options approach. real options is seen as an embedded options are being optimally exercised). First. The manage. perhaps by using point real options has been integrated with the broad forecasts and high hurdle rates. important evolution in techniques for valuing in. On the tical and biotech firms. they made the point that a major shut down their own business area? Or. one of the key value and resource requirements. sions over time. For example.quantify the value of individual projects or portfolios ment of the investment is not tied to the original of projects. real options provides an appropriate Typically. there is a tion. Indeed. profile emerging from a real options analysis rather Second. or market share. In these firms. Many managers agree that current deserves separate mention is the importance of systems often provide incentives that conflict with follow-up. As a result. Fourth. there tends to be a greater reliance on Monte There has been considerable discussion about Carlo simulation and risk-adjusted decision trees in designing internal performance appraisal and in- particular. The success of this So far. the results of the analysis firms use this roadmap to revisit an accepted project are summarized for review and approval by the on a regular basis to ensure that appropriate deci- appropriate senior management. options onto an existing process. Finally. sions are being made over time (i. as well and learning. profile of a project or portfolio of projects. in another results is a roadmap of future actions. options is often seen as competing with. the existing approach. the addition of real options changes way to track not only value creation but also the risk the process in some important ways. Such a project management process is particularly vestments. R&D portfolios in pharmaceu- when adopting a real options approach. that all the In many companies. context. ings) until oil prices move well “into-the-money?” 17 VOLUME 14 NUMBER 2 SUMMER 2001 . these firms are relying on an important in cases when there are no formal incen- investment evaluation process built around real tives for executing these options. forces a multi-disciplinary view in which the team several firms reported that they have enterprise risk proceeds through stages of framing. the major use of real options in this overlay strategy is likely to depend on the nature of project and portfolio management organizational the existing process and the types of real options mode is in specific areas of capital investment. ation and optimal exercise of real options within One feature of real options in this context that the corporation. how many managers are realized only if the firm actually executes the plan. more commonly. Option Third. In contrast. tional performance measures and value maximiza- ment. rewarded for exercising a put option to contract or Furthermore. across these two classes of assets and then appropri- plex and non-standardized nature of options in this ately managed. In some of these firms. as an contribution of the real options approach is that it example of a more subtle conflict between conven- enforces the concept of ongoing project manage. it rein. and presentation of results.

While Texaco management. Third. Texaco found porate real options into the portfolio planning process that this superior version of real options had in order to provide the best overall mix of investments several appealing features. processes are dynamic project management to ex- ority over conventional approaches. other management processes. project management. However. the right major capital investments. Texaco had strong major strategic investments. and move forward in this endeavor. a real options approach. ties as well as new technology businesses. Texaco decided to test. Texaco began to explore as separate and different. it drew heavily on this is a substantial challenge. using a variety of techniques such With a great deal of accumulated experience in as DCF. Two key management the concept of real options. and Texaco began wider application of the major” energy firms was emerging that put Texaco approach in other exploration and production activi- in direct competition with companies with substan. major pilot project on a challenging exploration and ronment. recognizing its superi. For robust and broader strategic framing of the oppor. and performance ap- interest in piloting the application of real options praisal. a new breed of “super. and potentially adopt. and external. Texaco believes in a more holistic tunity in question. that achieving buy-in among both executives and the made intelligent investment and operational plan. and an international down- In the mid-1990s. 16. Texaco aims. rank-and-file. Texaco conducted a taking place in an increasingly challenging envi. and was doing quite well. it began with a and strategic positioning at the corporate level. The latter is a key to providing incentives for on an appropriate investment opportunity. EVALUATING AND MANAGING STRATEGIC INVESTMENTS AT TEXACO Texaco is one of a handful of major global finance theory. Second. and/or risk manage. Monte Carlo simulation. real options has yet to be formally years. A great part of the success of scaleable process that dovetailed with other man- Texaco and similar firms is their ability to identify agement processes. new tially greater resources. the issue for Texaco is how to take the next step. ment. Specialists were trained in key business ning difficult. optimal exercise of real options and value-based Around the same time. Texaco began to recognize stream portfolio. years. rather than being viewed Seeking improvements. maximum benefit. Texaco also aspires to combine gone a transformation from an academic specialty the real options approach with corporate risk manage- to a business-oriented practice with strong analyti. there do not appear to be formal systems developed to precisely tailor financial 18 JOURNAL OF APPLIED CORPORATE FINANCE . such as decision trees. where practical. while some firms have succeeded at integrated into performance evaluation and com- integrating real options deep into their capital pensation. experiences applying these techniques to competi. This led to an ecute the investment plan. real options had under. it needs to be better integrated with new technology were sometimes disappointing.16 But when one considers that most firms investment. while the financing decisions of the firm should carefully reflect instruments or contingent financing plans based off of formal real options analyses the risk-return profile of its portfolio of assets-in-place as well as its growth options. it could be applied as a energy companies. This project was successful at major swings. this effort was the help of outside consultants. With During the 1980s and early 1990s. and decision individual real options applications over the past few analysis. Finally. this is not at all surprising. First. to incor- cal and organizational foundations. have been using real options for fewer than five ment processes. both internal Given this background. analytical skills. ventures like e-business. For the real options approach to contribute fully to tive bidding for assets and in analyzing ventures in Texaco’s success. Real options has become a key the critical importance of top-notch investment enabler to the way Texaco evaluates and manages valuation and management. decision analysis. project portfolio. including record low levels. Texaco continues to familiar tools such as DCF. Oil and gas prices were going through production opportunity. and manage them appropriately. In sum. something very important to and orchestrated deployment of real options. In addition. Similarly. areas.

strategic planning. most firms begin by experimenting with learn about market conditions before fully ramping one or more pilot projects. Nevertheless. Few investment bankers have to codifying real options through an expert working date embraced real options analysis. on Wall Street. and customization. perhaps held back temporarily by exploring the use of real options in the organiza- lack of senior level buy-in. built into a project. conducting one or more pilot projects that are their intuition. operations. goals. or marketing phases analogous to R&D. In general. but some- taken by the many different corporate managers we times conflicting. tool but a framework to incorporate knowledge panies seem to be pleased with their initial work from various parts of the organization into the with real options. and full-scale “production”. and are eager to move on to investment decision-making process. specialist training. The marketing group has experience in understand- ceed with the adoption of real options in one leap. particularly if there is an advocate who has credibility with senior management. they have the momentum to move on. and important divisional finance groups. mar. have immediate appeal to strategic planners since tum in the adoption process. work that bridges the longstanding gap between for the vast majority of the managers interviewed.17 These pilot projects up a project. or should. substantial effort must be spoke with are quite varied. often the first to recognize option features that are lenges. in large part group. pro. whether spent on putting together the right team. as we discuss below. They also have expertise in Pilot Projects understanding the technical risks faced by the company that are often at the heart of the analysis. though at a pace that may differ appreciated that it presents not only a valuation considerably among companies. One of the strongest arguments that can be At the completion of each stage. Nevertheless. common path to the successful adoption of real and benchmarking the analysis. the impetus to explore the use the kind that typifies real options thinking. but are Employees from operations. strategy and finance. firm-wide. it is a carefully staged process of In most firms. and tends to reinforce. such as options to expand and contract production. cross-disciplinary teams should be formed to Firms at the later stages are breaking new ground— leverage and combine all this knowledge. As a result. more apt to follow conventional methods em- getting buy-in from senior-level and rank-and. but also to facilitate moving forward with adoption of these techniques based on a successful The approaches to implementing real options first implementation. tion. In contrast. in further stages. com. ing demand volatility and developing strategies to Instead. Very few companies want to. choosing by choice or by default. financial analysts are explicitly experimental. In fact. Getting approval for a limited budget to perform a pilot project experiment has not seemed to pose a major problem in most firms. Real options models gates must be passed early on to sustain momen. ployed by investment bankers and other analysts file managers based on the pilot projects. The key steps in this the dynamic modeling of uncertainty and decisions process are: is broadly consistent with. and much less so from those in treasury or other keting. Much of real option techniques has been coming more like the development and launch of an innovative from individuals involved in business develop- new product. are dealing with both analytic and organizational chal. prototype design. and because of the difficulty in applying real options to institutionalizing and integrating real options value a whole company rather than a single project. companies made for real options is that it provides a frame- choose whether or not to continue. and have relatively few role models. for instance. options—in fact. Scientists and engineers are the appro- need to be carefully designed not only to maximize priate experts to estimate success probabilities for 17. 19 VOLUME 14 NUMBER 2 SUMMER 2001 . it is clear that there is a the most appropriate project(s) to experiment with. Given these twin. companies that have the expectation is that the firm will proceed through been quick to embrace real options models have all these stages. the adoption of real options involves ment.WHAT ARE THE PRIMARY SUCCESS FACTORS what is learned about applying real options tech- IN USING REAL OPTIONS? niques.

level buy-in has been. In most firms. new busi. The valuations generated by the alterna. Projects that involve high volatility. for commodity many firms. and the process of selling real options have staged investments over long horizons (a series internally comes more from the “push” of one or a of growth options) would also highlight the impor. the “pull” by senior management is ibility are good candidates. executives are often too busy handling issues requir- support for the adoption of real options analysis seems ing immediate attention to be willing to spend time to come much more easily and quickly. few intellectually curious and entrepreneurial indi- tance of optionality[real options]. there is often Firms that have benchmarked a real options considerable skepticism about new techniques. tive techniques will likely be different. cessfully moved beyond the pilot stage typically are To the extent that there are people in the either careful. the next critical step is senior-level buy- in the pilot project analysis. or both.g. difficult at ness development) or contracts (e. Assuming that the pilot projects demonstrate ence in implementing real options models and the feasibility and desirability of a real options processes are brought in to facilitate and participate approach. firms that have suc- analysis. Consequently. planners to increase the value of pet projects. and significant flex. Frequently. but in addi. senior trading) where real option ideas provide a natural fit. large irreversible investments. there occasionally is a perception that tion.18 While projects that lacking. Finance professionals can best appreci. In firms where there is resistance or reluc- and the impact on a firm’s cost of capital and tance to adopt real options. In companies with projects (e. in.. these Senior Level and Rank-and-File Buy-in individuals should clearly be included in the pilot team.g. or because the level of uncertainty is relatively low.. the real options approach may produce new real options may simply be another way for strategic insights about how to time or scale the investment. and perhaps even by their associa- highlight.different stages of R&D and resources required at Many of the managers interviewed emphasized each stage. that great care must be taken in choosing pilot ate the interaction between a project’s risk profile projects. or continues to be. Most firms are equally able to identify projects for which traditional DCF investment needs to be made immediately (there are few or insignificant analysis provides relatively accurate valuations. a DCF analysis) have found that it becomes This skepticism may be increased by the perceived easier to make a case for adopting real options complexity of the “Nobel-Prize-winning valuation techniques. empirical demonstration of the benefit of using real There are several reasons why getting senior options. At many firms. analysis of a pilot project against a more traditional particularly if the “push” is coming from external analysis that the firm would have typically followed consultants rather than from an internal champion. of Long-Term Capital Management. these projects may viduals who appreciate the potential of the real take a long time to “prove” their value and thus provide options framework. process is the buy-in of key senior-level executives. such as the failure approaches. and perhaps most obvious.g.. This benchmarking exercise can serve to tools” involved. However. These include projects where there downstream decisions). to learn about real options. a single well-publicized financing strategy. what tion with well-publicized fiascos involving deriva- is the same and what is different from traditional tives and their pricing techniques. This and about how to create flexibility in the future. outside consultants with experi. perception may have become more prevalent in the 18. One or more successful pilots can go a long way The selection of an appropriate pilot project is to demonstrate the value of real options. (e. It was readily identify projects for which the use of real quite evident from our discussions that the single options is likely to provide noticeably different most important catalyst for widespread implementa- results from those obtained through traditional tion of real options in the firm’s decision-making techniques. lucky. would be little to no value for the embedded options—either because most of the 20 JOURNAL OF APPLIED CORPORATE FINANCE . First. one can out management support for such changes. All of these aspects of a project failure (whether legitimate or not) can mean the end must be integrated into a successful real options of the process. with the help of a concrete illustration. organization who have had experience using deci- sion analysis or option pricing techniques. Second. important as it will provide a showcase for the most firms have difficulty changing processes with- application of real options. Third.

ments of most firms. One particularly effective technique is to by quantifying these benefits. particularly the available resources. this should not necessarily Companies with many engineers and scientists be a red flag. a scaled-down analysis is not necessary be legitimately skeptical about the longevity of but compatibility with existing processes is likely to interest in real options. As with senior process to work with. to the extent possible. or flexibility). but also how best to design the commitment to incremental resources.and lower-level employees may look analyzed in a very systematic and detailed manner. compelling terms. First. especially if not only to decide whether or not to proceed with senior management has not made an appropriate the investment. presumably because of the ability of of strategic value (such as the creation of future these individuals to understand probability distri- growth options. the argu. lower the barrier to entry by reducing the time and tage. qualitative assessments techniques. For will exaggerate its complexity. these terms typically involve an Once the interest is well-established. Third. use and refinement of the real options approach. how then is senior- level buy-in achieved? Our interviews suggest a few Codifying Real Options lessons. Real options provides butions and their penchant for logic-based pro- a way to inject discipline into this decision process cesses. can play a role in alleviating this concern. firm. an approach must be sug. it is not a sufficient condition. A billion-dollar investment in a particularly in today’s flatter and leaner organiza. nate the real options process. the process should ably busy with their existing roles and obligations. processes. new manufacturing facility can and should be tions. direct evidence effort required to use real options. most from within the organization. Such projects were often accepted tend to experience very quick acceptance of these based on overly optimistic. these employees may have witnessed a variety of this is the primary application of real options. when successfully addressed resistance to real options real options was sometimes promoted as a magic through a concerted marketing effort directed at bullet to justify the high valuations of dot-coms and key personnel in the rank-and-file. In management fads (“flavors of the month”). Several firms have large firms that are constantly evaluating a large 21 VOLUME 14 NUMBER 2 SUMMER 2001 . and nicate such a story to senior management. facility for future flexibility needs. providing a tougher combine a pilot project success story with a senior standard.wake of the recent new-economy hysteria. In many firms. The combination of successful pilot projects ments in favor of real options must be couched in and widespread buy-in sets the stage for broader simple. developing a “scaleable” real option process that gested that recognizes the unique context of the integrates appropriately with existing processes. Given these challenges. Furthermore. rank-and-file employees are invari. The key elements of in the form of the pilot projects or examples from such a plan include: outside the firm. Some firms creating a working group of experts to coordi- have employed outside consultants to help commu. an in-house venture capital group These issues can be compounded by inertia— that has five employees and is evaluating 20 poten- the tendency to rely on known techniques—and by tial deals each quarter has to be able to conduct a real a lack of knowledge about real options that in turn options analysis in an accelerated time frame. and even a conventional DCF analysis that ignores options Intranet sites dealing specifically with real options. existing management. companies are reluctant to adopt processes that While buy-in at the senior level is a necessary consume large amounts of calendar or people time. For the senior manage. case for using real options ultimately needs to come Given the pressures of today’s economy. condition for the widespread acceptance of real It is thus important to design the real options options. Again. senior management be a major concern. it is critical to appeal to shareholder value and competitive advan. While it is true that real sentations by participants in the pilot stage. circu- options will likely deliver a higher value than would lation of other internal white papers. management endorsement. In contrast. embedded in the project. and may such cases. involving pre- other high-tech companies. also be scalable. at real options as one more burden. and not against. but the training specialists in key business areas. We refer to this of the benefits of the approach should be provided as “codifying” real options. At the same time. rather than beginning with the techni- cal superiority of the analytic approach. Second. Middle.

techniques are not required to properly value the opportunity. or of some externally ization” stage. have begun to explore this stage in the adoption of ing group. with other processes and systems. different types of problems (e. or from subject matter experts. and to develop a mindset result of the diffusion of real option techniques that aims to create and preserve real options when throughout the organization. the timing of each stage (analogous to the maturity date of an option) can be highly variable. it captures the loss in project value from waiting (either due to forgone profits or the effect of competition). the firm sible with other management processes. This work.20 It is equally important.. But. and to be adopted by different groups in an organization. the inevitable real options framework. The “convenience yield. however. users may not fully ation techniques to price contractual options. tends to be real options. the margin on selling the product may be much less uncertain. 22 JOURNAL OF APPLIED CORPORATE FINANCE . this 1980s. Other firms were using option valu- developed software package. and correlations do not appear in cal and contractual sides of their business followed standard DCF applications.g. Some firms were already using consulting group. Even if real options techniques are have largely progressed through the first three stages “hardwired” through the use of a set of internally and are now actively interested in the “institutional- developed standard templates. data.g. and may reflect differences between forward and spot prices on commodities. To our knowledge. Ac- however.e. that the incremental value that comes from “the right. but not the obligation” to make the future investment is minimal. scale institutionalization has not yet occurred. this ing.” which is analogous to a dividend yield for a stock. These firms control. The degree of correlation between uncertain variables is another important variable that must be carefully estimated. cording to many of our interviewees. has reached the stage where real options can be A successful real options process typically institutionalized across the firm and integrated fully requires oversight and coordination by a true “work. A handful of compa- the decision-making process in relation to the size nies we spoke with had already exposed hundreds of of the investment is critical. only one or two for concern that lack of experience could lead to firms have made major external pronouncements to misspecification of these inputs. some options are so deep-in-the-money.. As analysts throughout the orga. the ability to adjust the scale of designing projects or contracts. will obviously particular values over time. For prices of an input or output commodity. As real options begins their employees to the real options methodology. and strategy to understand the benefits of the appears to be only a matter of time. survey have passed quickly through the early gates It is important for key finance and strategy personnel of the staged adoption process. is often difficult to specify.19 key stakeholders (e. sion. had provided more detailed training to dozens of key templates and guidelines should be developed for personnel who would be conducting the analyses. Integrating the risk management of the physi- nience yields. For instance. conve. since inputs optionality[option features] became a natural exten- such as volatility. and to be able to overwhelming majority have only recently become recognize when an evaluation calls for real options interested in real options.number of projects. adding more complexity into the analysis. and option pricing it is also crucial to understand characteristics such as mean reversion and spikes. and they are arriving there in somewhat housed in the treasury department or in an in-house different ways. Volatility estimates. an R&D investment. there is justifiable cause naturally as well. Once real options has been codified. while revenues and expenses associated with a new product may both be highly uncertain. need to be obtained from available market or internal be exercised in the future. given that the to be well trained in real options. Wall Street analysts) regard- This group of experts should also be involved ing their use of real options. or how to the evaluation of physical assets to incorporate their properly estimate them. A few companies ing” (as opposed to “managing”) group. Finally. it is not surprising that full- and when it does not. for individuals from operations. jumps. a capacity planning decision. mean reversion. and transformed these processes into real group of experts can oversee the necessary quality options analysis techniques in the 1990s. rather than using standard assumptions of lognormality. or the probabilities of the stochastic variables reaching 20. These templates and guidelines should be coordinated as much as pos. in some applications such as R&D. For instance. decision analysis and related techniques in the nization begin to apply real options techniques. Most of the firms in our in the training of a broad cross-section of employees. if they are closely correlated. i. 19. market. Specifically. an equity investment. consisting of several experts. Institutionalizing Real Options or a licensing agreement). and understand what the inputs represent.

com). it is likely that these help managers make better investment decisions— techniques will gradually take hold on Wall Street. a wholly owned subsidiary of PricewaterhouseCoopers (adam.WHAT DOES THE FUTURE HOLD FOR REAL mous—feeling that the answer to this question is OPTIONS? yes. is real options going? Will this a discount to their value will be more quickly process accelerate or stall. that its fortunes are tied to the condition of the new and the outcome is tied as much to the uncertain economy. It may well be that they created value for the parent company not by creating options at a cost below the “true value” of the option. other companies will various real options approaches. Analysis. The first and. but rather by taking advantage of overvaluation of these options in the market. if in important parts of many companies. modest evolution is occurring decision processes are deficient. Others feel observe only whether the outcome is good or bad. the continued acceptance of The second is a “push” from Wall Street. However. then. but as a general way of thinking nomena indicate that this rate will increase. over long the plunge in Nasdaq prices.) 23 VOLUME 14 NUMBER 2 SUMMER 2001 . there language and use similar valuation techniques for will likely be increasing convergence among the evaluating projects internally. drawn their value by divesting assets or businesses—or by upon research and consulting resources. since one can remains primarily an academic pursuit.g. other factors can quite clear. communicated in the future. ALEX TRIANTIS ADAM BORISON is Associate Professor of Finance at University of Maryland’s is Partner and Leader of the ROVtm practice at Applied Decision Robert H. Second. (Appendix on following page. real options will serve not simply affect the rate of adoption dramatically. Two phe- as an analytical tool. companies that make better deci- corporate practitioners paint a different picture. These firms firms are able to create options and then monetize have built on the academic foundations.21 of real options change over time? While the benefits of real options will deter- Based on our interviews.pwcglobal. and how will the practice recognized. and related. Furthermore. in a more rigorous and intensive way. Unfortunately. 21.edu). as more companies speak the organizational process. In the long run. Barnes and Noble) were able to quickly realize the value of their internet growth options. their portfolio—the gains from creating options at Where. seemingly unani. as an is a network effect. While real real options will likely depend on the answer to options is a difficult tool to apply accurately in one very important question: Does real options valuing an entire company.com (e. detectable in the energy and life sciences industries. and are selling equity positions in specific businesses in actively adopting the real options approach. Such an effect is already “decision analytic” and “option pricing” approaches. particularly the follow their example. there and language by which value will be measured and is an overwhelming—in fact. First. Companies that issued stock on an internally generated dot. Our discussions with periods of time. they will provide a common framework firm’s shareholders? Based on our interviews. Smith School of Business (atriantis@rhsmith. it is impossible to obtain defini- tive proof that this process indeed leads to the right Some observers may feel that real options decision in an individual case. and that its prospects have dimmed with world as to the decision. It sions should prosper relative to those whose appears that a quiet.borison@us.umd. the evidence seems mine its long-term acceptance. decisions that end up creating more wealth for the In so doing.

RESULTS: 6. and what training do they 3. is your firm satisfied? Why? II. Where have you applied real options? In particu. failure? Where Have You Applied Real Options? Why? 1. Which executives in your firm are now most individual projects. least lar. How has your firm reacted to real options? In particular. 4. How have the applications changed as you gain 2. 1. what organizations. Black- Options? Scholes? 1. How and when did your firm learn about it? more experience? 3. equity How Is Real Options Regarded? analysts) expressed interest in real options? 1. What kind of follow-up process do you have your firm? after a real options project to monitor progress? 4. What does “real options” mean to your firm? 4. generally? Why? ners have in your firm. Who in your firm has expressed the most interest in real options? The least interest? IV. How has it been applied organization. a center of excellence. How was interest in real options communicated 6.g. Do you expect the use of real options to grow ally? In particular. what issues? valuable about real options? Why? 3. [binomial] lattices. METHODS: V. portfolios? supportive of real options? Why? III. What has been your biggest success. What changes must be made to the practice of get? real options to increase its acceptance? Why? 24 JOURNAL OF APPLIED CORPORATE FINANCE . 5. trees. How does real options interact with other within your firm? management systems. such as compensation? 5. What do you now find most valuable.APPENDIX: SURVEY QUESTIONS I. Monte Carlo. Do you expect the use of real options to grow 2. What was it about real options that interested 5. What are the major challenges you now see in options? applying real options? Why? 2. in your firm? Why? consultants? 2. Board. When and where did your firm first apply real 3. How widely is real options used? In particular. Have your stakeholders (e. How has it been applied analytically? In particu- Where/How Did You Learn About Real lar.. APPLICATIONS: 2. THE FUTURE: How Have You Applied Real Options? Where Is Real Options Going? 1. What background do real options practitio. EXPOSURE: 3.