Real options are those related to investment decisions
– options to embark on an investment, to defer it or abandon it.
– options to expand or contract an investment.
– option to undertake an investment in stages.
– options to make investments now that may lead to greater opportunities later, sometimes called ‘toe-in-the-door’ option.
– options to switch input or output in a production process.
Valuation of real options
The Black-Scholes model can be used to value real options, but the following should be noted:
The exercise price will be replaced by the capital investment (initial investment).
The price of the underlying item will be replaced by the present value of future cash flows from the project.
Time to expiry is replaced by the life of the project.
Interest rate is still the risk free rate.
Volatility of cash flows can be measured using typical industry sector risk.
Option to redeploy or switch
The option to redeploy or switch exist when the company can use it productive assets for activities other than the original one.
The switching from one activity to another will be exercised only when the present value of cash flows from the new activity will exceed the cost of switching.
This could result to a put option if there is a salvage value for the work already performed, together with a call option arising on the right to commence the new investment at a later stage.