Answer 1:

Real Option is defined as a choice (an option) to be taken for investment in a particular business
opportunity among many other options available. Basically, such decisions are taken by the managers
of the company. It is referred as REAL because it deals with the investment opportunities relating to
tangible fixed assets rather than financial instruments (i.e. Shares, bonds etc.). It is a right to choose
an opportunity but not an obligation.
Abandonment: In case an opportunity or a project is selected and in the due course you realise that it
cannot give expected returns, then you have an option to stop/leave the project. Such an option to
abandon the project during the course of its life time is known as Abandonment. If the NPV’s from
that project are not positive or as expected by top management then the project or asset could be
abandoned.
If this option is not considered, we would end up continuing with the same project, estimating wrong
cashflows for the future years and finally will end up in losses.
Timing: An investment opportunity with positive NPV does not always mean that we should go
ahead with the project. As per Timing option, it justifies that if we can delay the investment decision
today we will have another more options waiting in the future. The optimal timing is a trade-off
between cash flows today and cash flows in the future.
If this option is not considered, we may no choose the right project at the right point of time. If the
project’s NPV does not accrue cash inflow in the time frame then the firm will suffer losses due to
changes in forecasted schedule.
Growth: Growth is related to the expansion of the project. Growth option means to make additional
investments into an already existing project. Sometimes, additions into an project with negative
cashflows can trigger to give positive cashflows. The growth rate of the incomes from a project
decreases as its NPV declines.
Growth factor is important because if we fail to estimate the growth of a particular project( which is
not good at present) which will give high returns in the future, the we may end up slipping a good
opportunity due to lack of estimation of growth.
If growth options are not incorporated properly, firms won't be in a position to determine proper fixed
capital investments and working capital.
Flexibility: Firms often have an option to vary the inputs used into the production or change the
output to be produced from production. Such options are known as flexible options. Flexible
production options are in particular valuable within industries where the lead time (time between an
order and delivery) can extend for years.
The NPV is least effected by the flexible projects. If the project was accepted and execution is flexible
then the project could be revised or abandoned to minimize losses. We can modify the decision taken
for a particular project when required.

Answer 2:
(note: “Company” here means company/firm/organization/any business)

The precise value of real options can be difficult to establish or estimate. Real option value may be
realized from a company projects, such as buildings etc. By doing so, the company may realize a
goodwill benefit that makes it easier to obtain necessary permits or approval for other projects.
However, it’s difficult to pin an exact financial value on such benefits. In dealing with such real
options, a company’s management team factors potential real option values into the decision-making
process which involves huge initial investment. Hence, Companies have to increase their initial
investment costs for effective results.

The most common method of valuing real options currently is a form of binomial tree following a
latticed (flexible) model. Monte Carlo simulations are also often used in the evaluation of real options.

Return on the Cost Invested is a measure of financial performance expressed as a percentage of how
much profit a company is generating for every dollar that is invested in it. Return on cost incurred to
obtain a real option shows that a company is worth to incur such cost invested in it to generate
income.

When the real options are implemented successfully at the right time considering abandonment,
timing, growth and flexibility of the company, the company stands worthy of the costs so spent to
obtain a suitable real option.

Answer 3:
Many a times, one doesn’t know the market perfectly well and in those cases one would be stuck with
initial capacity or production required to invest. The Optimal level of Capital budget is an annual
investment in long-term assets that maximizes the firm’s value. To attain such level the firm need to
understand the real options in the business. The Real options are abandonment, timing, growth and
flexibility options.
Failure to recognise any of these options would most probably cause a firm's capital budget to deviate
from its optimal level.
Yes, a failure to recognize growth options tend to cause a firm’s actual capital budget to be above or
below the optimal level. Yes, my answer would be the same even for abandonment, timing, and
flexibility options.
If growth options are not incorporated properly, firms won't be in a position to determine proper fixed
capital investments and working capital.
If timing option is not considered, the project does not account for the time value of money.
If abandonment is ignored then the firm will keep on investing in an unproductive project which
should have been winded off.
The firm should be much flexible to get adopt to any situation that arises and make proper investment
decisions as per the situations. If not the firm cannot mould itself if any new opportunity arises and as
a result it loses good projects.