Brealey, Myers, and Allen on Real Options

Real options are valuable sources of flexibility that are either inherent in, or can be built into, corporate assets. The value of such options are generally not captured by the standard discounted cash flow (DCF) approach, but can be estimated using a variant of financial option pricing techniques. This article provides an overview of the basics of real option valuation by examining four important kinds of real options: 1. The option to make follow-on investments. Companies often cite strategic value when taking on negative-NPV projects. A close look at the payoffs from such projects reveals call options on follow-on projects in addition to the immediate cash flows from the projects. Today s investments can generate tomorrow's opportunities. 2. The option to wait (and learn) before investing. This is equivalent to owning a call option on the investment project. The call is exercised when the firm commits to the project. But often it's better to defer a positive-NPV project in order to keep the call alive. Deferral is most attractive when uncertainty is great and immediate project cash flows which are lost or postponed by waiting are small. 3. The option to abandon. The option to abandon a project provides partial insurance against failure. This is a put option; the put's exercise price is the value of the project's assets if sold or shifted to a more valuable use. 4. The option to vary the firm's output or its production methods. Companies often build flexibility into their production facilities so that they can use the cheapest raw materials or produce the most valuable set of outputs. In this case they effectively acquire the option to exchange one asset for another. The authors also make the point that, in most applications, real-option valuation methods are a complement to, not a substitute for, the DCF method. Indeed DCF, which is best suited to and usually sufficient for safe investments and "cash cow" assets, is typically the starting point for real-option analyses. In such cases, DCF is used to generate the values of the "underlying assets" - that is, the projects when viewed without their options or sources of flexibility