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Financial Modeling with Crystal Ball and Excel, + Website, 2nd Edition by John Charnes

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CHAPTER 13

Real Options

This chapter describes real options analysis (ROA), and shows how Crystal Ball and OptQuest can help you determine the value of real options. As we have seen, a financial option is the right, but not the obligation, to buy (or sell) an asset at some point within a predetermined period of time for a predetermined price. ROA is used as an alternate methodology for evaluating capital investment decisions involving a high degree of managerial flexibility, such as research and development projects or new product decisions. Unlike the simple net present value (NPV) method used in traditional finance theory, ROA treats an investment opportunity as either a single option or a compound option (a sequence of options). The traditional NPV method does not value managerial flexibility correctly when it relies on the false assumption that an investment is either irreversible or that it cannot be delayed.

In this chapter, we will see the similarity between financial and real options, then discuss applications of ROA and some analytical methods that have been used with real options. The real option valuation (ROV) tool described in the final sections combines the use of Crystal Ball and OptQuest to determine the value of opportunities that contain real options.

13.1 FINANCIAL OPTIONS AND REAL OPTIONS

With a financial option, the initial investment in an option contract buys the potential opportunity to enjoy positive cash flow when future spot price changes of the underlying ...

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