“Real options allow managers to make future decisions that change the value of capital budgeting decisions made today”
How are real options paid for? Does a company approach a bank to buy these options to protect itself from unforeseen losses?
Does anyone know the process of this?
Thanks. I’d rather understand it fully than memorize this section.
H Doobsmeister,
My understanding is a real option is NOT something that is traded (i.e purchased) at the start of the project.
It is simply the knowledge that at some point in the future the project will give the ‘Option’ to do something… only at that point in time will you pay for that option.
As long as the PV of the different between the benefit and cost is greater than zero from today’s point of view then the Real option wll add value to the project.
A real option, ironically, is not “real” in that it does not really exist. It is defined as real because in comparison to simply agreeing with someone to purchase the option to puchase a security at a price in the future it is an option to execute on a corporate finance project in the future.
Think of real equalling the “real” corporate investment by, say, buying a machine halfway through the project is complete, versus unreal- simply clicking a button on a computer to purchase a sheet of paper at a later date.
I see, so an example would be:
A real estate investor signs a contract with a seller, and in that contract there is an option to abandon the project if certain events occur prior to execution. Is this a “real option”? So from my understanding, a real option is embedded in a contract with a counterparty similar to how OTC markets work, but in this case, it is “real” (e.g. Real Estate, Plant expansion). Do I make sense here?
Thanks again guys.