This is one of the earliest examples of a real options contract, wherein Thales bought an option—a right, but not an obligation—to rent the presses, the underlying risky asset. This is called a real option, not a financial option, because the underlying asset is a real asset, not a financial security. Thales basically took advantage of the uncertainty of the payoff associated with renting out the presses and exercised his option to rent the presses only when it was in his favor.

How can a manager in a 21^{st} century corporation use a similar real options-based approach to make the right decisions at the right time? Before we address this question, let us first review the discounted cash flow (DCF) analysis, the most used technique today for project valuation.

**Discounted cash flow**

DCF analysis involves first estimating the free cash flows over the project life cycle and then calculating the net present value (NPV) by discounting them back to today. There are two fundamental problems with DCF:

- It takes a deterministic approach by using just one value of NPV, which is rather probabilistic in the real world. Thus, DCF does not consider the uncertainty of future outcomes.

- It also does not consider a manager’s flexibility to change the course of the project. For example, you may want to wait until some of the uncertainty clears before investing. Furthermore, after a small initial investment—for testing the waters, if you will—you may abandon, contract, or expand the project depending upon how the project unfolds. DCF considers investment decisions as single point in time decisions without valuing the managerial flexibility to alter the future project outcome.

**A simple example to show discounted cash flow limitations**

Let’s say you have a chance to invest $100 in a project. In one scenario, the NPV is expected to be between $100 and $120 and in another between $70 and $150. The DCF analysis, which does not account for the uncertainty, will put the project NPV at $110 in either case. Assume that this return does not meet your investment benchmarks, so your decision will be not to invest in the project irrespective of the scenario.

But what if an initial small investment (say $10) will help settle the uncertainty giving you an option to fully invest in the project later only if the return is favorable but abandon it otherwise? Your decision is likely to change now for the second scenario. If your payoff is expected to be $150 (or relatively high), you will invest in the project or else you will walk away. Thus, by considering the uncertainty and accounting for the managerial flexibility, you can make the right decisions to minimize losses and maximize returns. DCF analysis does not consider such choices.

**Why real options? **

Real options analysis accounts for the uncertainty of the payoff as well as the managerial flexibility to change the course of the project. It gives you the value (in monetary units) of the project taking into consideration the initial as well as the future decisions you would make on the project. You can more accurately estimate the value of your investments based on the options you have. Following are some typical examples of real options:

- Deferral Option. An oil wildcatter may want to wait to drill for oil until oil prices rise.

- Abandon Option. A software developer may consider abandoning the operations in a foreign market.

- Expansion Option. A fast growing healthcare product company may weigh the option to expand by acquiring a smaller company.

- Contraction Option. An airline may need to contract its services due to lower demand and higher competition.

- Chooser Option. A manufacturing plant owner may be faced with a choice between continuation of the status quo, expansion, contraction, or total abandonment of the plant facility.

- Switching Option. An industrial facility may want to switch its boilers between using natural gas and No. 2 fuel oil based on the relative fuel prices.

- Sequential Option. A drug developer may want to manage their multi-staged drug development process with an option to abandon or continue the project at each stage.

Using real options valuation (ROV) technique you can calculate quantitatively the value (again, in monetary terms) of these options and overall project investments to make the right decisions at the right time.

**Calculation of real options valuation **

Several methods are available to calculate the option value of a project, and the choice depends on the simplicity desired, available input data, and validity of the method for a given application. Calculation of ROV has its roots in financial options, thanks to the Nobel prize winning work of the MIT economists, Fisher Black, Myron Scholes, and Robert Merton. These are highly sophisticated quantitative methods, and I discuss them in detail in my book on real options.

**When does real options provide value? **

The value of real options is a function of the project payoff uncertainty, the managerial flexibility with available alternative decision choices, and management’s willingness to exercise the options. When uncertainty is little and there is not much room for managerial flexibility, ROV does not offer much value. It is most valuable when the uncertainty and the managerial flexibility are both high and management is willing to exercise the options.

Furthermore, ROV offers additional information for “go/no go” decisions based on the evaluation of projects for their own merit as well as relative merit against other competing projects in a portfolio. ROV can offer you additional value in comparing projects that are “equal” based on DCF/NPV alone, thereby acting as a “tie breaker”.

Real options should not be construed as a means to justify projects that should be turned down in the first place. If a project has a extremely high negative NPV, it probably should be rejected.

ROV is not a substitute for the DCF/NPV method. It supplements and integrates the latter into a more sophisticated valuation technique.

**Real options in the real world **

ROV is a relatively new technique to evaluate strategic project investments. Many business professionals have shied away from ROV perhaps because of the higher level of mathematics involved in ROV calculations. Unfortunately, many consultants in this area have promoted a “black box” approach to ROV. Those who truly understand the principles behind real options appreciate the value ROV brings to strategic assessments and have embraced the method. Energy and pharmaceuticals are the two sectors where ROV has made inroads, but it still has a long way to go.

More than two thousand years ago, Thales may have used real options to prove the wisdom of the Sophists, but today’s executives need real options to make the right decisions at the right time to increase profitability from their project investments.

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