590 Part Six Options
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Recall that the value of a real call option can be expressed as a position in the underlying
asset minus a loan. Thus the call behaves like a claim on the underlying asset partly financed
with borrowed money. The borrowing does not show up on the corporation’s balance sheet,
but it is nevertheless really there. The implicit borrowing is a debt-equivalent obligation that
must be valued using an after-tax interest rate.^20
The implicit borrowing creates off-balance-sheet financial leverage. The resulting finan-
cial risk is the reason why the real call option’s value is more volatile than the value of the
underlying asset. (The real option would have a higher beta than the underlying asset if both
were traded in financial markets.)
In Chapter 18 we pointed out that highly profitable growth companies like Google and
Amazon use mostly equity finance. These companies’ real growth options are one explana-
tion. The options contain implicit debt. If the growth firms’ CFOs recognize the implicit
debt, or at least the extra financial risk attached to the options, they should reduce ordinary
borrowing to compensate. Option leverage therefore displaces ordinary financial leverage.
The displacement means that if you forget to count debt both on and off the balance sheet, a
growth firm will appear to be less leveraged than is actually the case.Practical Challenges
The challenges in applying real-options analysis are not conceptual but practical. It isn’t
always easy. We can tick off some of the reasons why.
First, real options can be complex, and valuing them can absorb a lot of analytical and
computational horsepower. Whether you want to invest in that horsepower is a matter for busi-
ness judgment. Sometimes an approximate answer now is more useful than a “perfect” answer
later, particularly if the perfect answer comes from a complicated model that other managers
will regard as a black box. One advantage of real-options analysis, if you keep it simple, is
that it’s relatively easy to explain. Complex decision trees can often be described as the pay-
offs to one or two simple call or put options.
The second problem is lack of structure. To quantify the value of a real option, you have to
specify its possible payoffs, which depend on the range of possible values of the underlying
asset, exercise prices, timing of exercise, etc. In this chapter we have taken well-structured
examples where it is easy to see the road map of possible outcomes. For example, investments
in pharmaceutical R&D are well-structured because all new drugs have to go through the
same series of clinical trials to get approved by the U.S. Food and Drug Administration. Out-
comes are uncertain, but the road map is clear. In other cases you may not have a road map.
For example, reading this book can enhance your personal call option to work in financial
management, yet we suspect that you would find it hard to write down how that option would
change the binomial tree of your entire future career.
A third problem can arise when your competitors have real options. This is not a problem
in industries where products are standardized and no single competitor can shift demand and
prices. But when you face just a few key competitors, all with real options, then the options
can interact. If so, you can’t value your options without thinking of your competitors’ moves.
Your competitors will be thinking in the same fashion.
An analysis of competitive interactions would take us into other branches of economics,
including game theory. But you can see the danger of assuming passive competitors. Think of the
timing option. A simple real-options analysis will often tell you to wait and learn before invest-
ing in a new market. Be careful that you don’t wait and learn that a competitor has moved first.^21(^20) The interest on the option debt is also implicit and therefore not tax-deductible. The proof that the discount rate for real options
should be after-tax is in S. C. Myers and J. A. Read, Jr., “Real Options, Taxes and Leverage,” NBER Working Paper 18148, June 2012.
(^21) Being the first mover into a new market is not always the best strategy, of course. Sometimes later movers win. For a survey of real
options and product-market competition, see H. Smit and L. Trigeorgis, Strategic Investment, Real Options and Games (Princeton,
NJ: Princeton University Press, 2004).