While the argument that some or many investments have
valuablestrategicorexpansionoptionsembeddedinthemhas
greatallure,thereisadangerthatthisargumentcanbeused
to justify poor investments. In fact, acquirers have long
justifiedhugepremiumsonacquisitionsonsyn-ergisticand
strategic grounds. We need to be more rigorous in our
measurementofthevalueofrealoptions andinouruseof
realoptionsasjustificationforpayinghighpricesormaking
poor investments.
When real options are used to justify a decision, the
justificationhastobeinmorethanqualitativeterms.Inother
words, managerswhoarguefor investingina projectwith
poorreturnsorpayingapremium onanacquisitiononthe
basisoftherealoptionsgeneratedbythisinvestmentshould
be required to valuethese real options and show that the
economic benefits exceed the costs. There will be two
argumentsmadeagainstthisrequirement.Thefirstisthatreal
optionscannoteasilybevalued,sincetheinputsaredifficult
to obtainandoftennoisy. Thesecondisthat theinputsto
optionpricingmodelscanbeeasilymanipulatedtobackup
whatever the conclusion might be. While both arguments
havesomebasis,anestimateisbetterthannoestimateatall
andtheprocessoftryingtoestimatethevalueofarealoption
is, in fact, the first step to understanding what drives its value.
Tests for Expansion Option to Have Value
Notallinvestmentshaveoptionsembeddedinthem,andnot
all options, even if they do exist, have value. To assess
whetheraninvestmentcreatesvaluableoptionsthatneedto
be analyzed and valued, we needto understandthree key
issues.