REAL OPTIONS: TAKING
STOCK AND LOOKING
AHEAD
Young Li,
Barclay James,
Ravi
Madhavan, &
Joseph
Mahoney
2007
Advances in
Strategic
Management
ARTICLE OVERVIEW
 A concentrated report on developments in ‘real options
theory’ and how ‘real options’ ideas can ef fectively be used
 A discussion on the past, present, and potential future of Real
Options Theory research and literature
 Real Options Defined –
 A Real Option is the right to undertake some action or decision in the
future (i.e. the option to ‘make’, ‘abandon’, or ‘contract’, etc.)
REVIEW OF CURRENT REAL OPTIONS
LITERATURE
 Investment Decisions
 Implications of common real options on investment strategies
 Investment Mode Choices
 The effects of real options on governance and organization
 Performance Implications
 How real options analysis and understanding affects valuation and
performance
APPLICATIONS OF REAL OPTIONS
THEORY
INVESTMENT AND DIVESTMENT
 Wait-to-invest
 In cases of uncertainty and high irreversibility of investment, a firm
may choose to invest later rather than immediately
 Allows firm to wait for favorable conditions
 Abandon and switch
 Real Options theory proposes that the value of a put option increases
with salvage value and future uncertainty
 Adds divestment considerations to NPV analysis
 Corporate growth
 Decisions made not necessarily for immediate cash flows, but for
value derived from potential future benefits and returns
INVESTMENT AND DIVESTMENT
 Option Interactions
 Additional options increase the value of investment projects
 Substitutable options add flexibility to investments, increasing value
 ‘Dueling’ options take place of each other but have differing value
 Options Portfolios
 Strategic decisions can be viewed as bundles of real options
 R&D project portfolios can be viewed as a portfolio of options
 Alliances can be viewed as ‘exploratory investments in real options’
INVESTMENT AND DIVESTMENT
 Competitive Dynamics
 Investments are made with the industry as a whole in mind
 Options are weighed with first-mover advantage, competitive entry,
sector monopoly/dominance, etc.
 Uncertainty and Learning
 In general, uncertainty increases the value of real options
 Two types:
 Exogenous – resolved with time, encourages waiting prior to investing
 Endogenous – reduced by strategic investments, reveals learning
opportunities and can encourage investing
 Investments can be made by a firm to influence uncertainty to their
advantage
ORGANIZATION AND GOVERNANCE
 Choice of Investment Modes
 Real options can affect a firm’s choice in investment modes
 Real options weigh heavily on the ‘make or buy’ decision
 Example - Exogenous technological uncertainty leads to a preference
for equity collaboration over acquisition
 Collaborative Ventures
 Trading of real options between partners can create joint gains
 Optimal equity shares of a joint venture can be determined by the
real options each partner holds
VALUATION AND PERFORMANCE
 Valuation
 Risk-neutral probabilities of success are smaller for early -stage
ventures & positively related to the number of prior financing rounds
 Implied volatility is larger for early -stage ventures and are negatively
related to the number of prior financing rounds
 Performance Implications
 Option pricing models may not readily apply to real investments
(because of differences between real and financial options)
 Businesses that link small options with large strikes will perform
better than those who stay small or large
 Firms with greater exit value and less specialized assets are worth
more to investors
THE FUTURE OF REAL OPTIONS
RESEARCH
 Investment




Real options/learning and resources and capabilities
Investment decisions from a real options perspective
Exit/abandonment decisions
Interactions between real options and option -like projects
 Investment Mode Choices
 Governance choice and contractual issues
 Performance Implications
 Real options theory and organizational performance
 Cost of real options creation and exercise
 Firm and industry-level influences on investment performance