CHAPTER 9
REAL OPTIONS FOR INVESTMENT VALUATION
This chapter considers investments that can be staged such that decisions can be made at each stage whether or not to continue investment for the next stage. This multistage approach provides decision makers with considerably flexibility. This flexibility enables hedging against the downside possibility that an investment no longer makes sense because either an earlier stage has failed or the opportunity for which the investment was targeted no longer makes sense.
Framing investment decisions in this way results in each decision to proceed with the next stage as equivalent to purchasing an option on the subsequent stages. The option is the right, but not the requirement, to invest in the next stage at a later time. If the results of the current stage are positive, and the opportunity embodied in the next stage still looks attractive, then one can exercise this option and proceed.
The decision to proceed with investing in the next stage may, in effect, result in the purchasing of an option on the subsequent stages. In this way, the series of investment decisions may be represented as a stream of option purchase decisions, followed by option exercise decisions. Only at the last stage is the asset deployed in the marketplace. However, as later discussion shows, this deployment can also be represented as creating another option for future market offerings.
This chapter proceeds as follows. First, the nature of options is elaborated. ...
