Saturday, December 4, 2010


Strategic real options

They are a number of investments that may contain elements that could provide valuable opportunities to a firm in the future. Some investments may not be profitable but for the attractive opportunities that they are capable of creating in the future. For example, a chemical company may invest in R & D that may help it to develop new chemical and exploit it to introduce new products in the market. Similarly, a fast moving consumer products company may interest in a brand to leverage sales of it is other products. A fertilizer company may install a small plant to manufacture and sell caprolectum to see the reaction of the market, and scale up the plant in future if demand is high. These opportunities are highly valuable and must be identified future opportunities or flexibility is more valuable than investments without such Strategic elements.

real options are Strategic elements in investments that help creating flexibility of operations, or that have the potential of generating profitable opportunities in the future for the firm. Real options provide discretion to managers to take certain investment decisions, without any obligation, for a given price. We may clarify that real options are not confined to real assets only. Patent, R & D brands etc are examples of assets that have a value to that owner. The capital investments should be viewed as strategic investments that incorporate real options. Hence the value of capital investments will also include the value of the strategic elements in the investment. Valuing real options is real challenge for managers.

The option pricing theory provides a framework for the valuing Strategic investments. The methods of the valuing real options are the same as the financial options although it is difficult to identify the values of certain inputs in case of real options. An investment with real option consists two values the value of cash flows from the projects assets plus the value of any future opportunity arising form holding the asset. Like in a financial option an exchangeable asset underlies a real option. For an example, the underlying asset in the case of an option to expand is the value added to expansion. The cost of expansion is the exercise price.

Some capital investments have embedded options. Managers must recognize and value these options and exercise them when it is advantages to do so. Of firm can attain flexibility and make commitments by internationally creating a simple option in to investment projects. It can obtain flexibility by creating long positions in call or put options. for example, right to expand or right to enter a new venture in the future at a given price is a long position in call option, and right to abandon or right to liquidate in the future at a given price is a long position in put option. A firm may agree to disinvest or some large investment projects may involve complex options. There may be options on options, or options may be interdependent or mutually exclusive. Managers must play an active role in identifying or creating options, valuing them, monitoring them and using them appropriately to create values for the company.

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