Strategic Options (Real Options)
Thinking of project option features in capital budgeting is essential. For example, firms have A real option depends not on an underlying financial asset (such as a stock), but on an underlying real asset.
the ability to shut down production if the market price of their output product were to fall. That is, a project that allows management to curtail production when it is unprofitable is the equivalent of a call option with a strike price that depends on the price of the output good. Such options are called real options, because their exercise depends on the value of “real” assets, rather than on the value of financial assets. The house with a mortgage was a real option.
If the base asset is a stock price in the future, we know the underlying stock price today and that the rate of return until expiration is roughly normally distributed. If the underlying base asset value (e.g., the house or the firm’s output product or the firm’s input product [e.g., gold or oil]) is similarly roughly normally distributed, we can even use the Black-Scholes formula to value the derivative asset. Doing so replaces the need to estimate the appropriate cost of capital, E ( r ), on the project with the need to estimate the variance, σ ( r ). (Usually, estimating volatility is easier and more reliable.)
However, the most important aspect of real options is to recognize their presence, not the method of valuation. Whether the B-S Formula is used to avoid estimating the appropriate cost of capital, or a CAPM type formula with an expected cash flow estimate is used to obtain the appropriate cost of capital, is of relatively less importance. The big mistakes that managers often commit is that they fail to value the real option at all.