The valuation model we present here is a binomial model, so called because in each time period the value can only go up to one particular value or down to another. Yet the technical difficulties of real options are easy to address: There are valuation methodologies that effectively capture the complexities and the iterative nature of managerial decisions, and the Black-Scholes-Merton model is not the only, or even the most appropriate, way to value real options. What’s more, in the wake of the high-tech collapse, it’s easy to see why people might be skeptical of a valuation tool that arguably exaggerated those companies’ growth potential.Ĭritics are right to point out problems with the most widely used option-based methodologies for valuing a company’s growth choices. Their concern is that it would be dangerous to try to reduce those complexities into standard option models, such as the Black-Scholes-Merton model, which have only five or six variables. As many executives point out, options embedded in management decisions are far more complex and ambiguous than financial options. The reasons for this high defection rate seem just as sensible as the reasons for using the tool and are usually based on technical grounds. Also in 2001, a “Management Tools and Techniques” survey by Bain & Company of 451 senior executives who had tried the real-options approach showed that fully a third of them had given up using it that same year. Indeed, a survey of 4,000 CFOs published in 2001 by John Graham and Campbell Harvey found that 27% of the respondents claimed they “always or almost always” used some sort of options approach to evaluating and deciding upon growth opportunities.īut there are, it seems, at least as many customers who are dissatisfied with this tool. It’s therefore appropriate that managers have begun to apply option theory to help them make decisions about these projects. These projects are thus options-“real” options, as opposed to financial options-in which managers have the right but not the obligation to invest. These projects-research and development, investments in new capacity, geographical expansion, and other initiatives-are seldom simple onetime decisions in most cases, a company’s investments are multistaged, and at each step the company may push ahead or pull out after gaining new information. The market values a growth company largely by estimating the prospects of its portfolio of growth projects. The trigger points should not only tell managers when they need to decide on exercise but also specify rules governing the exercise decisions. To improve the way it manages its real options, a company can look out for the decision trigger points that correspond to the nodes on a binomial decision tree. Such gaps may be largely the result of managers exercising options at the wrong time. The authors also address another criticism of real options: that gaps often arise between theoretical and realized values of options of all types. These calculations provide you with numbers for all the possible future values of the option at the various points where a decision needs to be made on whether to continue with the project. Then you work backward from the value at completion, factoring in the various investments, to determine the value of the project today. To use the binomial model, you must create an “event tree” to figure out the full range of possible values for the plant during the project’s lifetime-next year, at the end of the design phase, upon completion. Suppose your company is considering investing in a new plant. Binomial models, by contrast, are simpler mathematically, and you can tinker with a binomial model until it closely reflects the project you wish to value. Many of the problems with real-options analysis stem from the use of the Black-Scholes-Merton model, which isn’t suited to real options. In this article, the authors make the case that the complexity of real options can be eased through the use of a binomial valuation model. Yet many companies hesitate to apply options theory to initiatives such as R&D and geographic expansion, partly because these “real” options are highly complex. Each corporate growth project is an option, in the sense that managers face choices-push ahead or pull back-along the way.
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