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The Real Option Theory

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Managerial Finance | Use of Real Options Theory in Financial Management/Modeling | Tiffany Allen | BUS 650 | Prof. Achilles | 11/14/2011 |

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Abstract

In business, as in life, you always have options to choose from. In today's extremely unstable market, managers realize how incredibly risky some investment opportunities can be, and how useful a flexible strategy can be. Using real options theory, managers can more effectively analyze opportunities to pursue, delay, modify, or abandon projects as events unfold. This paper analyzes the use of real option theory in financial management and modeling. It discusses issues included in the implementation of the theory in financial management and modeling. It explains new learning in real option theory and a case study that was able to apply the theory along with the application of the theory to my current business which has helped me understand real option theory.

Use of Real Options Theory in Financial Management/Modeling

The Real Option Theory has struck some interest with managers in the last couple of decades. Back in the day, companies had plenty of time to make decisions to make changes when they felt it was necessary. Now, if they take their time deciding on changes, chances are by the time they finally make a decision, another company has already made the move. Times have change and especially with how the economy is today, it’s a “Dog Eat Dog World” and in this competitive market, you have to make moves quickly and intelligently if you want to survive as a company. The Real Option Theory has helped gather concepts from financial economics and use them to make much better decisions. The Real Option theory is different from other theories as it shows the combined importance of uncertainty and managerial discretion in a company which gives a broad view of a company’s investment, governance and decision making. Real Option Theory can also bring financial markets into strategic thinking. One issue with this theory is that people have different views on the advantages of the real option in strategy. Realistically, organizations go through many changes and face many uncertainties which in turn demand new ways for strategic thinking. Real Option offers help with overcoming uncertainties and issues while providing better strategic thinking tools for the financial analysis for the organization. Real Options could provide things like analytical flexibility that some other valuation models might lack. Real Option means an alternative or a choice or option given with a business investment opportunity. These options are referred to as “real” because they, in most cases, pertain to tangible assets, like capital equipment rather than financial instruments. (Investopedia.com) A real option in financial management/modeling would include applying option valuation techniques to the capital budgeting decisions. There are many decisions that can be made, for example, to leave or expand on a business investment. Real options can help make better decisions in uncertainty conditions. These are “opportunities embedded in projects or investments that are likely to exist and have a material economic impact on cash flow and risk.” (Financialmodlingguide.com) In investments, the Real Options Theory is hugely important in the decision making process. It has modified the Net Present Value Theory which was used to make decisions on investments. In an investment, the Net Present Theory assumes that the future cash flow is estimated and determined if there is an uncertainty. If the NPV is positive, then the project should be considered. If the NPV is zero, then the company can decide if they want to pursue the project or reject it. The Net Present Value Theory has not been effective for managers because it has shortcomings. The Real Options Theory on the other hand has made decision making easier and has helped overcome issues in financial management. (Mun, 2006) “Real options capture the value of managerial flexibility to adapt decisions in response to unexpected market developments. Companies create shareholder value by identifying, managing and exercising real options associated with their investment portfolio. The real options method applies financial options theory to quantify the value of management flexibility in a world of uncertainty.” (Real-options.org) The Real Option Theory can be used as a theoretical instrument as the managers can characterize and communicate the strategic value of the project. Most traditional methods do not allow this and they do not give management the option of flexibility. They usually do not account for uncertainty and risk in the lifecycle of the project and they also do not adapt well to risk adjustments. Many learning’s have occurred since the Real Options Theory has been used in financial management and modeling. Different types of businesses need different types of options so researchers have done lots of research to determine new and applicable types of options for different styles of businesses. (Mun, 2006) Many managers have different and mixed feelings about the Real Option Theory and its helpfulness for proper decision making, but usually it is because they are not looking at the correct options for their type of business. A non business Real Option would be the decision whether or not to get your Masters Degree or not. In week one of BUS 650, Managerial Finance, we worked on a case in chapter 4 in our text that discussed this option for a man named Ben Bates. We determined factors, such as his age and how it affected his decision. Also, non- quantifiable factors were also considered when making the decision on whether Ben should complete his MBA. Some of these non-quantifiable factors including, but are not limited to: additional knowledge to be better at his current position, a high grade point average and its relation to a pay scale after graduation, opportunities that may or may not open up for him once he graduates school, self fulfillment, feeling achievement, more knowledge, having a higher level of confidence that will shine through to the people that are interviewing him for a higher position.
The case study puts into account three options including continuing to work and not going to school, choosing Wilton college, or Mount Perry college. Putting into considerations of cost of the different schools and the loss of money during the duration of Ben being in school were all considered. (Ross & Westerfield, P. 131) This case was helpful to understand that Real option can be used in business and in real life, non business situations as well.
Risk can be involved when a financial manager is making a decision on whether or not a project will be beneficial to stockholders’, a good return on investment, and if they should abandon or expand. “Effective and efficient planning for and management of project risk requires the management of uncertainty. Real options can be an effective tool for managing uncertainty and thereby increasing project value.” (Ford & Lander, 2011) Some managers do not use real options, they prefer to intuitively manage uncertainty. It is extremely important to understand the similarities and differences between decision-maker perceptions of real options and real options theory as it is critical for improving the use of real options for risk management. (Ford & Lander, 2011) Effective policy dealing with costs cannot be made without a strong understanding of the implications of Real Options Theory for policymakers who attempt to replica the market behavior of firms in competition.
Real Option offers a means of flexibility for the management to address uncertainties as they are resolved. Traditional capital budgeting does not account for this flexibility and to also fails to integrate with strategic planning. Some examples of options that are included in this flexibility includes: defer, abandon, shutdown and restart, time-to-build, contract, switch, expand and grow. (Alleman, 1999) “Real options offer the possibility to integrate major analytical methods into a coherent framework that more closely approximates the dynamics of the firm’s behavior without heroic assumptions regarding the dynamics of the environment.”(Alleman, 1999)
I currently work for Waste Management and they use Real Options on a regular basis. Waste Management INC is North Americas leading provider of integrated environmental solutions. The company's goal is to maximize resource value, while minimizing environmental impact so that both our economy and our environment can thrive. Serving over 20 million residential, industrial, municipal and commercial customers, Waste Management posted $12.52 billion of revenues in 2010. They are constantly making decisions on what recycling and waste programs they should offer and in what parts of the country. Trash and recycling may seem like a simple business, but there is so much more to it than people realize unless they have worked in the industry.
On the operations side, it is deciding what cities and towns to offer service in that are not franchised through the city, and then determining what types of services to offer. WM does not offer recycling in every town, because some towns do not have as much interest in recycling as some areas of the country. They also have to determine how far out they want to service in some areas where they will start losing money. They will only service a route if there are several accounts in that route, after they have to determine when they will do pickups in that area and how frequent they offer pickups. For example, they may only offer once a week pickup so someone may have to get a larger container because they cannot have 3 times a week pickup. They also may chose to cancel a route and stop servicing an area if it is not beneficial to the company to do so.
There are different categories of real options which can occur when performing financial model on a project or investment. I have applied to following options to Waste Management for better understanding:
Abandonment option is the option to terminate or abandon a project before the end of its lifespan. This option helps project owners avoid losing money on projects that take a turn for the worst. A financial modeler, when recognizing this option and evaluating a project often increases the net present value. (Financialmodelingguide.com) In this example, Waste Management hired a group of 30 employees for a team called the “Warm Lead Team” and there job was to take incoming calls and qualify them for service, determining if we service their area and if they are not under contract with a competitor. If they were qualified, then the warm lead team was trained to set them up for a phone appointment and have a sales representatives call them and sell them services. WM found that they were losing customers because they had to wait for an appointment and by then they may have signed with a competitor. They decided to abandon this team setup and move all these employees into sales positions or another department. Eliminating that middle step allowed for more sales.
Flexibility Option is the option to include a large degree of fluctuation and flexibility into an organizations operation, in many cases manufacturing and production. Typically, this includes the design the manufacturing and the production process to be able to accept multiple inputs. They will also be able to use flexible manufacturing techniques and technologies to make various outputs by reconfiguring the same set of equipment. They will purchase an retain excess capacity in capital intensive industries that are subject to many fluctuations in output demand and long lead time within building a new capacity. (Financialmodelingguide.com) If using this model in a financial and analysis exercise involving capital expenditure should be able to increase net present value. For Waste Management, we have 25 different market areas and they all do their operations differently and they change it all the time. There is a great deal of flexibility involved with changing routes, switching trucks between different market areas, offering different product options etc.
Growth Option is an option to develop continuing businesses or projects, expand in new markets, increase plants, etc. These options would not be possible without the ongoing existence of the project being implemented. Projects being considered are expected to create cash flow and open new avenues of growth potential and often increase the project’s net present value. (Financialmodelingguide.com) At Waste Management new avenues of growth are constantly being considered and implemented. They open recycling to new markets where they only offered trash before. Also, they are always looking for new routes to offer services in and expanding. We are not in all 50 states at this point but the goal is to expand all our routes to all states and to offer all recycling services to all states as well.
Timing Option is the option determines when the range of actions of the project will be implemented. This opportunity also determines whether or not they should delay or postpone a project by slowing down or temporarily discontinuing the project. (Financialmodelingguide.com) At WM we have a team called the “SWAT Team” and they are given different projects to complete. Once the next project is chosen, WM has to decide when the best time is for this team to tackle this project. Currently they are on a project to call every account in Seattle, WA that we currently service for trash services and offer recycling. WM was not offering recycling in that city previously so now they opened up recycling there and put a center with trucks and hired employees to provide this service. They set up the service as soon as the city started becoming more environmentally cautious and then decided when the best time was to send in the SWAT Team to start selling recycling. Once they feel like they have saturated the market in that area enough, they pull out of that project and start the next project which could be to call every hospital, medical office, dentist office, and veterinary clinic in a certain area and offer Medical Waste disposal services.
When planning a project, using past financial accounting statements and gathering data of the competitive market will be useful, however, with new projects, there will be limitations, but estimation of the percentage values can be created. Financial managers may exercise the Real Options Theory as a chain of useful solutions to foresee a potential future outcome of a project. New products and the amount of capital to invest as well as the funding needed to make an expansion or either to realize that the project would not work are all things that have to be estimated under the Real Options Theory. Growth of a company would not occur if they only duplicated products that were already out in the market place. Theoretically, it is understandable why many companies would utilize this theory. In Conclusion, the Real Option Theory can be applied in many areas including financial management and modeling. This theory allows managers to make better decisions on investments and projects. This can help them decide whether or not to enter a new market, expand within the areas around them, add a new product line, discontinue a project, etc. Real Option Theory allows them to evaluate things that may not have a track record to imitate. Managers must account for risks and uncertainty when making decisions. This theory allows for changes in the risk and in the project themselves. The Real Option Theory offers a great deal of flexibility and has provided strategies and tools to analyze financial information. Although not all managers are on board with the use of the Real Option Theory, those whom have found a way to properly apply it to their business have found it extremely beneficial. Others just do not know how to apply it to their type of business so they do not see the positive effects of the theory. Many learning’s have taken place and many researches have been implemented to find more and more options that can be useful in more businesses. I was able to think back to the first week when we used Real Option Theory to help decide whether or not Ben Bates should or should not go back to college to obtain his MBA. This was a great example of a non business example of the use of this theory. I was also able to connect my learning’s of this subject and the Real Option Theory to my current work experience with Waste Management and it helped me better understand how our company applies this model to their decision making process when deciding to expand, pull out of a market, or offer new services in new areas. After researching deeper into the Real Option Theory, I do not see why a company would not at least try to utilize this theory in their decision making process.

References
Alleman, James, (1999) The New Investment Theory of Real Options and Its Implications for Telecommunications Economics, Regulatory Economics Series, Kluwer Academic Publishers, Boston, MA.
David N Ford, Diane M Lander. Real Option Perceptions Among Project Managers. Risk Management. Basingstoke: July 2011. Vol. 13, Iss. 3; pg. 122, 25 pgs
Mun, J. (2006) Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions. John Wiley & Sons.
"Real Option Definition." Investopedia.com - Your Source For Investing Education. Web. 13 Nov. 2011. <http://www.investopedia.com/terms/r/realoption.asp>.
"Real Options in Theory and Practice." Real Options. Web. 14 Nov. 2011. <http://www.real-options.org/>.
"Real Options (Strategic Options) in Financial Modeling | Financial Modeling Guide." Financial Modeling Tutorial, Advice, Tips and Tricks · Financial Modeling Guide. Web. 14 Nov. 2011. <http://www.financialmodelingguide.com/analytical-tools/real-options/>.
Ross, S., & Westerfield, R., Jaffe, J., & Jordan, B. (2011). Corporate finance: Core principles and applications (3rd ed.). Boston, MD : McGraw-Hill Irwin.

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...Flaws with Black Scholes & Exotic Greeks Treasury Perspectives Flaws with Black Scholes & Exotic Greeks 1 Flaws with Black Scholes & Exotic Greeks 2 Flaws with Black Scholes & Exotic Greeks Dear Readers:It’s been a difficult and volatile year for companies across the Globe. We have seen numerous risk management policies failures. To name a few... UBS, JPM Morgan, Libor manipulations by European, US and Japanese banks and prominent accounting scandals like Lehman… As rightly said by Albert Einstein “We can't solve problems by using the same kind of thinking we used when we created them.” and when you can't solve the problem, then manage it and don’t be dependent upon science as Science is always wrong, it never solves a problem without creating ten more. The same is the case with Foreign Exchange Risk Management Policies (FXRM) which if can’t be managed properly then would lead to either systematic shocks or negative implications at the bottom line of the corporate, banks, FI and trading houses P&L A/cs. That is something risk management struggles with, say the experts. In Richard Meyers’ estimation, risk managers or traders do not socialize enough. “It’s all about visibility,” he said. Meyers, chairman and CEO of Richard Meyers & Associates, a talent acquisition and management firm in New Jersey, relates the story of a firm that decided to adopt an Enterprise Risk Management (ERM) strategy. Instead of appointing its risk manager to head...

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