Option Pricing with

Applications to Real Options

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Cadence Design Systems, which develops electronic products and services, pro-

vides an illustration of a real option. Rather than create all the necessary software it-

self, Cadence often contracts with specialized software developers. As a part of the li-

cense, Cadence must make a royalty payment to the software developer each time it

sells a product that contains the software. Many of the software contracts build in a

floor that requires Cadence to make a specified minimum number of royalty pay-

ments, even if actual sales are lower than the floor. Because the expected demand for

Cadence’s products is uncertain, sales may be less than the floor, causing Cadence to

make a large payment without revenue to cover it. Of course, if sales are higher than

expected, Cadence must make more royalty payments than expected, but then it

would also have high revenues and thus could afford the payments.

In negotiating with its software suppliers, Cadence proposed an arrangement

that had a relatively low floor but a higher per-unit royalty. Using a standard NPV

analysis, Cadence’s proposal produced a negative NPV. However, option pricing tech-

niques showed that Cadence’s proposed royalty arrangement actually added value.

As you read this chapter, think about the ways that option pricing techniques

can lead to better decisions.

Sources:Peter Coy, “Exploiting Uncertainty: The ‘Real-Option’ Revolution in Decision-Making,” Business Week,

June 7, 1999, 118; and S. L. Mintz, “Getting Real,” CFO, November 1999, 52–60.

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