Syllabus B. Advanced Investment Appraisal B2. Application of option pricing theory in investment decisions

B2b. Real options in decision making 3 / 7

Syllabus B2b)

Evaluate embedded real options within a project, classifying them into one of the real option archetypes.

Real options are those related to investment decisions

These are:

  1. Timing options

    – options to embark on an investment, to defer it or abandon it.

  2. Scale options

    – options to expand or contract an investment.

  3. Staging options

    – option to undertake an investment in stages.

  4. Growth options

    – options to make investments now that may lead to greater opportunities later, sometimes called ‘toe-in-the-door’ option.

  5. Switching 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.