Real Options Theory

The application of option pricing theory that is used to evaluate call and put options in order to evaluate investments in real assets, such as acquisition of plant, equipment, and other fixed assets. Whereas call and put options pricing deals with pricing financial assets, real options theory deals with strategic decision making in investment in real assets—plant, equipment, land, and buildings—by applying call and put options pricing models to capital budgeting techniques. Capital budgeting is the application of financial techniques to evaluate investments in projects and products that increase the value of the firm. These techniques will lead to an accept or reject decision of whether to undertake the project

A call or put option is the right and not the obligation to buy or sell a financial asset such as a stock. Similarly, a real option is the right but not the obligation to invest in real or physical assets. Financial options are generally traded on organized markets such as the Chicago Mercantile Exchange. However, real options cannot be traded on organized markets because the owner of a real option cannot sell its rights in the investment in a plant or equipment in an organized market.

Real options theory research is growing and has attracted much attention. Investing in real assets has options, similar to exercising a call or put option, to invest or not in real assets or projects. These investment options are sometimes difficult to evaluate using traditional capital budgeting techniques because many investment opportunities and projects contain embed ded options that make the discount rates or risk-adjusted discount rates difficult to estimate. This problem can be dealt with by applying options pricing theory to assess whether to reject or accept an investment opportunity. Applying the real options model to the evaluation of an investment avoids the need to estimate the risk-adjusted discount rate.

Real options theory can also be used to value a business. Valuing a business the traditional way, such as using the price/earnings multiplier or calculating the present value of the future cash flows using the risk-adjusted cost of capital, does not give a good valuation for new businesses because new businesses tend to have negative earnings during the first few years. There are also many other applications of real options theory. It can be used to evaluate whether to sell or close down a project, whether to make further investments, whether to reduce the scale of a project's operation, or whether to defer a project and extend the life of an asset. For more information, see Hull (2006).