PART 3: CAPITAL BUDGETING11- 3 REAL OPTIONS
We turn now to a method of analysis in valuing projects that draws from our discussion of options in
Chapter 8. You may recall that financial options are securities that allow an investor to secure access to
making a decision in the future: for a small fee, a call option allows us to take up the option at a future
date to buy something; and a put option allows us the option to sell something. This idea of having
choices during a project which were not available in the original design of the project – for example, to
delay the start of a project, to expand its scale, to diminish its scale, or to stop it before its original final
date – gives great flexibility to our valuation process; and we can use option-pricing logic to determine
these values. By recognising the options embedded in a project or investment, we can more fairly value it.11- 3a WHY NPV MAY NOT ALWAYS GIVE THE RIGHT ANSWER
Only a few decades ago, the net present value method was essentially absent from the world of corporate
practice. Today, it has become the standard tool for evaluating capital investments, especially in very
large companies. Even so, NPV can systematically overstate or understate the value of certain types
of investments. These systematic errors occur because the NPV method is essentially static. That is,
NPV calculations do not typically take into account potential future actions by managers that may
increase the value of an investment once it has been made. When managers can react to changes in the
environment in ways that alter an investment’s value, we say that the investment has an embedded real
option. A real option is the right, but not the obligation, to take a future action (such as cancel or delay)
when implementing a project. Note that these actions can change an investment’s value. We presented
an in-depth analysis of financial option pricing techniques in Chapter 8, so only a brief reminder is
presented here.
A simple example shows where NPV can go wrong. Suppose that you are bidding on the rights
to extract oil from a proven site over the next year. You expect extraction costs from this field to run
about $79 per barrel. Suppose oil currently sells for $75 per barrel. You know that oil prices fluctuate
over time, but you do not possess any unique ability to predict where the price of oil is headed
next. Accordingly, you assume that the price of oil follows a random walk, meaning that next period’s
value equals this period’s value plus or minus a random shock. Because future and past oil prices are
statistically unrelated, your best estimate of the future price of oil is simply the current price. How
much would you bid?
An NPV analysis would tell you not to bid at all. If your best forecast of the future price of oil is $75
per barrel, then you cannot make money when extraction costs are $79 per barrel. The expected NPV of
this investment is negative, no matter how much oil you can pump out of the ground.
A real options approach to the problem yields a different answer. If you own the rights to extract oil,
you are not obliged to do so if the price is too low. You reason that you will pump oil only when the market
price is high enough to justify incurring the extraction costs. Predicting exactly when the price of oil will
be high enough to make pumping profitable is impossible, but historical price fluctuations persuade you
that the price of oil will be higher than extraction costs at least some of the time. Therefore, extraction
rights at this site are worth more than zero.^6real option
The right, but not the
obligation, to take a future
action (such as cancel or
delay) when implementing
a project. Note that these
actions can change an
investment’s valuerandom walk
When next period’s value for
a variable equals this period’s
value plus or minus a random
shock. When financial asset
prices follow a random walk,
future and past prices are
statistically unrelated, and the
best estimate of the future
price is simply the current priceLO11.5Under what conditions might an
NPV calculation recommend the
wrong investment decision?
thinking cap
question
6 To determine exactly how much these rights are worth, we must use techniques that were presented in Chapter 8.