The Quarterly Review of Economics and Finance, Vol. Copyright 8 1998 ‘Ikustees of the University of Illinois All rights of reproduction in any form reserved ISSN 1064-9769
INTRODUCTION Real Options:
GEORGE E. PINCHES of Missouri-Kansas
It is widely known that the investments firms make in capital and human assets is dynamic, not static. In order to model the dynamic nature of capital investments the traditional discounted cash flow approach leading to the NPV (net present value) decision rule is being augmented by valuing the options inherent in, or that can be built into, a firm’s investments. Advances in real options have been dramatic, but many challenges remain-especially in applying real option concepts and ideas to the capital investment decision-making process employed by firms. The backbone of the real options approach to capital investment decisionmaking is recognizing that the concepts and approaches for valuing options on financial assets can be applied to valuing the strategic and timing options held by firms. However, at least three additional complexities exist with real options which generally are not present with options on financial assets. These are: 1.
Real options held by firms are generally much more complex than financial options. This occurs especially in the areas of across-time strategic interdependencies and the compoundness of multiple options within the same capital project. Hence, modeling becomes challenging, and many of the ideas and developments for valuing options on fmancial assets do not work very effectively when valuing realistic real options. Ownership of real options is generally nonexclusive (that is, more than one firm may own or can develop the real option). This creates a problem because there is often competitive interaction, and the value of a real option may depend, in part, on the action of other fu-ms. At the extreme, the real option held by a firm may be preempted by the action of other firms. Hence, the value of many real options is determined by how exclusive the option is, how quickly the firm acts, and/or the actions of competitors.
REVIEW OF ECONOMICS
The underlying asset (except for some natural resources) is generally not traded in most real option situations. Even if the underlying asset is traded, it is traded only in imperfect markets. While not examined here, one avenue for significant future research is the valuation of options in imperfect markets.
The purpose of this Special Issue is to highlight recent developments in real options, and indicate some of the approaches that are moving us closer to applying real option concepts and ideas to assist firms make more effective capital and human investment decisions. The first paper, “Challenges to the Practical Implementation of Modeling and Valuing Real Options” by Diane Lander and George Pinches, examines some of the issues faced in modeling real options. One conclusion of this paper is that it may be necessary to resort to other approaches, such as decision trees or influence diagrams, to model realistic real options. Part I of the Special Issue, “Extensions to the Traditional Capital Budgeting Framework,” contains three papers that examine different issues that arise when the real options approach to modeling capital investment decisions is employed. Christine Brown and Kevin Davis, in “Options in Mutually Exclusive Projects of Unequal Lives,” present a simple example indicating the option problem that approach for dealing with mutually exists with the traditional “replication” exclusive projects with unequal lives. Next, Ronald Spahr and Robert Schwebath, in “Comparing Mean Reverting Versus Pure Diffusion Interest Rate Processes in Valuing Postponement Options” show that assuming mean reversion in interest rates, as opposed to assuming a pure diffusion process, may significantly lower the value of the postponement option. Finally, in “Interest Rates, Inflation and and the Value of Growth Options” Kathleen Hevert, Robyn McLaughlin Robert Taggart examine the value of growth options in the presence of interest rate changes. They find the value of the options is significantly impacted by how much of the change in the discount rate a firm can “flow through” to its customers in the form of higher cash flows. These papers provide specific examples of why it is important to consider capital investments in a real options framework. In Part II, “The Role of Competition and Strategy,” the focus shifts toward some of the issues related to the strategic implications of taking a real options approach, and the impact competition has on the value of real options. Using a hypothetical example, Richard Ottoo, in “Valuation of Internal Growth Opportunities: The Case of a Biotechnology Company,” models a firm and indicates the positive impact competition may have on the speed of development. Then, in “Investment in Innovations and Competition: An Option Pricing Approach,” Ariane Reiss examines the interaction between patenting an innovation and the actions of competitors. While not directly building competitor action in using a game theoretic approach, the paper indicates many of the issues raised, and insights obtained, when competitive interaction impacts the value of the options held by a firm. Finally, Andrew Chen, James Conover and John Kensinger, in
“Valuing Flexible Manufacturing Facilities as Options,” present a thorough discussion of flexible manufacturing facilities and the inferences that arise from taking a real options approach to corporate strategy. While we have long known there are substantial relationships between capital investments and corporate strategy, the real options approach provides a rich framework for further exploring these interrelationships. In Part III, “Issues in Application,” some of the problems that arise when applying the real options approach are considered. Sylvia Panayi and Lenos Trigeorgis, in “Multi-stage Real Options: The Cases of Information Technology Infrastructure and International Bank Expansion” examine two specific applications of the real options approach to capital investment decision making. Next, Simone Kelly in “A Binomial Lattice Approach for Valuing a Mining Property IPO” uses available data to estimate the value of an IPO, and finds the actual initial market value of the IPO is greater than the option-based estimated value. This is followed by Simon Rose, “Valuation of Interacting Real Options in a Tollroad Infrastructure Project” where Monte Carlo simulation is employed to value interacting options. Then, Graham Davis in “Estimating Volatility and Dividend Yield When Valuing Real Options to Invest or Abandon,” examines how volatility and dividend yield (or “rate of return shortfall”) can more accurately be estimated for real options involving mineral resources. This is followed by an example using data from an actual mining project. Finally, Gonzalo Cortazar a and Jaime Casassus, in “Optimal Timing of a Mine Investment: Implementing Real Options Model” demonstrate how software can be developed to make the implementation of the real options approach far more user-friendly. In addition, they provide sensitivity analysis and indicate how many other variables can be incorporated into real options modeling software. While all of these papers indicate the challenges and the potential for implementing the real options approach, the application of real option decision making in firms is still in its infancy. I would like to thank the authors for making this Special Issue a reality. While a lot has been accomplished in the last 10 to 15 years in understanding and valuing real options, much still remains-especially as we move from theory to the implementation of the real option framework to assist firms in making more effective capital investment decisions. It’s a topic of great practical importance.