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The Engineering Economist, 50: 2553Copyright 2005 Institute of
Industrial EngineersISSN: 0013-791X print / 1547-2701 onlineDOI:
10.1080/00137910590917026
MAKING USE OF REAL OPTIONS SIMPLE: AN OVERVIEWAND APPLICATIONS
IN FLEXIBLE/MODULAR DECISIONMAKING
Lenos Trigeorgis
Bank of Cyprus Chair Professor of Finance, University of
Cyprus,Nicosia, Cyprus and President, Real Options Group
This article focuses on how the use of real options can be made
simple,providing an overview of the power of flexible and modular
decision mak-ing and its use in various applications across
industries. After commonreal options are discussed through a
comprehensive example, the arti-cle reviews the key lessons and
implications of real options thinking forflexible decision making.
It then proceeds to propose a modular problemstructuring approach
that allows simplifying of complex real option prob-lems by
decomposing them into a few basic building-block option types
(re-viewed) connected by some basic decision operators. The
resulting problem-structuring option map is depicted in a range of
illustrative applicationsin various industries. Past areas of
application of real options as well asresearch challenges ahead are
also discussed.
INTRODUCTION
In an increasingly uncertain and dynamic global market place,
managerialflexibility has become essential for firms to
successfully take advantageof favorable future investment
opportunities, respond effectively to tech-nological changes or
competitive moves, or otherwise limit losses fromadverse market
developments. Thinking of future investment opportunitiesas real
options has provided powerful new insights that in many
waysrevolutionized modern corporate resource allocation. Real
options empha-sizes the importance of waiting (e.g., McDonald and
Siegel [34]) or stagingflexibility, suggesting that managers should
either wait and see until sub-stantial uncertainty is resolved and
the project is more clearly successful,
Address correspondence to Lenos Trigeorgis, Bank of Cyprus Chair
Professor of Finance,University of Cyprus, 75 Kallipoleos, P.O. Box
20537, CY 1678, Nicosia, Cyprus. E-mail:[email protected]
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26 L. Trigeorgis
requiring a premium over the zero-NPV, or they should stage the
decisionso that they can revise the situation at critical
milestones to either proceedto the next stage or abandon. During
the waiting or staging period, new in-formation can be revealed
that might affect the desirability of the project;if future
developments turn out worse than expected, the firm has
implicitinsurance protecting it against downside losses by choosing
not to proceedwith the project.
Real options also introduces a new insight with respect to the
role andimpact of uncertainty on investment opportunity value that
runs counterto conventional thinking. Since management is
asymmetrically positionedto capitalize fully on upside
opportunities while it can limit losses on thedownside, more
uncertainty can be beneficial for option value. More can begained
from opportunities in highly uncertain or volatile markets
becauseof the exceptional upside potential and limited downside
risk that resultfrom managements flexibility to proceed or not
proceed with the project.
From a strategic perspective, of course, it may not always be
benefi-cial to wait and see. For example, by making an early
strategic R&Dinvestment, a firm may not only develop more
cost-efficient or higher-quality products or processes that can
result in a sustainable cost or othercompetitive advantage, but may
be able to positively influence compet-itive behavior and earn a
higher market share down the road. In somecases a firm anticipating
competitive entry may make a strategic invest-ment commitment
(e.g., in excess production capacity) early on such thatit can
preempt competition altogether. Therefore, optimal investment
tim-ing generally involves a trade-off between wait-and-see
flexibility and thestrategic value of early commitment. Moreover,
early investing may itselfopen up a set of new options embedded in
the commercial project (e.g., tolater expand, abandon, or switch to
alternative uses), whose value may alsobe enhanced by higher
uncertainty, but is realized through early investing.Thus, the
presumed depressive impact of uncertainty on investment is notthat
clear-cut. The above new considerations of investment under
uncer-tainty suggest the need to adopt an expanded or strategic NPV
criterion,able to capture managements flexibility to alter planned
investment deci-sions as future market conditions change as well as
the strategic value ofcompetitive interactionsbesides the value of
expected cash flows fromcommitted assets (e.g., see Trigeorgis [50,
52, 55, 56]).
The rest of the article is organized as follows: The next
section providesan overview of some common real options through a
comprehensive ex-ample. Key lessons we have learned about real
options in terms of maininsights and implications are then
discussed, followed by discussion onsimplifying real-life problems
and reducing them to a basic problem struc-ture. A review of real
options applications is given next, while the finalsection
catalogues challenges that future research must focus on more.
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Making Use of Real Options Simple 27
OVERVIEW OF COMMON REAL OPTIONS:A COMPREHENSIVE EXAMPLE
The following example involving a natural resource extraction
and pro-cessing facility serves to review many of the most common
options en-countered in long-term capital investment opportunities.
A large naturalresources company has a one-year lease to start
extracting minerals on un-developed land with potential reserves.
Initiating the project may requirecertain exploration costs, to be
followed by construction of roads and otherinfrastructure outlays.
Planned investment outlays are indicated as It , whileVt indicates
the value of the projects expected operating cash flows at timet .
The initial investment in exploration is I0, and the investment in
roads andother infrastructure in the first period is I1. This is
expected to be followedby capital outlays, I2, for the construction
of a new processing facility. Ex-traction can begin only after
construction is completed; i.e., cash flows aregenerated only
during the operating stage that follows the last outlay. Dur-ing
construction, if market conditions deteriorate, management can
chooseto forego future planned outlays past the current stage.
Management mayalso choose to reduce the scale of operation by c%,
saving a portion, IC ,of the last outlay (I2) if the market is
weak.
The processing plant can also be designed up front such that, if
mineralprices (or the quantity of reserves) turn out unexpectedly
high, the rateof production can be enhanced by x% with a follow-up
outlay of IE toinstall extra capacity. At any time, management may
salvage a portionof its investment by selling the processing plant
and equipment for theirsalvage value or switch them to an
alternative use value, At . An associatedrefinery plant, which may
be designed to operate with alternative sourcesof energy inputs,
can convert the raw mineral into a variety of refined by-products.
We enumerate hereafter the real options embedded in this typeof
project.
1. The option to defer investment. The lease enables
managementto defer investment for up to one year and benefit from
the res-olution of uncertainty about mineral prices during this
period.Management would invest I1 (i.e., exercise its option to
extractthe mineral) only if mineral prices (or reserves) are
sufficientlyhigh, but would not commit to the project, saving the
plannedoutlays, if prices (or reserves) are low. Just before
expiration ofthe lease, the value added will be the greater of the
net valuecreated (that is, V1 I1) or $0, with value added
represented asmax (V1 I1, $0). The option to defer or invest is
thus analo-gous to an American call option on the gross present
value ofthe completed projects expected operating cash flows, V1,
with
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28 L. Trigeorgis
the exercise price being equal to the required outlay, I1.
Sinceearly investment implies sacrificing the option to wait, this
op-tion value loss is like an additional investment opportunity
cost,justifying investment only if the value of cash benefits
actuallyexceeds the initial outlay by a substantial premium. The
optionto wait is particularly valuable in such resource extraction
indus-tries, as well as in farming, paper products, and real estate
devel-opment, due to high uncertainties and long investment
horizons.
2. The option to stage investment. In most real-life projects,
therequired investment is not incurred as a single up-front
outlay.The actual staging of capital investment as a series of
outlaysover time creates valuable options to continue with the
projector abandon it at any given stage (e.g., after exploration if
thereserves or mineral prices turn out very low). Thus, each
stage(e.g., building necessary infrastructure) can be viewed as an
op-tion on the value of subsequent stages by incurring the next
costoutlay (e.g., I1) required to proceed to the next stage and
cantherefore be valued similar to compound options. This option
isvaluable in all R&D-intensive industries, especially
biotechnol-ogy and pharmaceuticals; in highly uncertain,
long-developmentcapital-intensive industries, such as
energy-generating plants orlarge-scale construction; acquisition or
market entry strategies;high-tech start ups; and venture
capital.
3. The option to expand. If mineral prices, reserves, or other
mar-ket conditions turn out more favorable than expected,
manage-ment can accelerate the rate or expand the scale of
production(by e%) by incurring a follow-up cost outlay (IE). This
is sim-ilar to a call option to acquire an additional part (e%) of
thebase-scale project, paying IE as exercise price. The
investmentopportunity with the option to expand can be viewed as
thebase-scale project plus a call option on future investment
[i.e.,V + max(eV IE, 0)]. Given an initial design choice,
manage-ment may deliberately select a more expensive technology
withbuilt-in flexibility to expand production if and when it
becomesdesirable. As discussed further below, the option to expand
mayalso be of strategic importance, particularly if it enables
thefirm to capitalize on new or future market growth
opportuni-ties. When the firm buys vacant undeveloped land, or when
itbuilds a flexible plant in a new geographic location (domesticor
overseas) to position itself to take advantage of a develop-ing
potentially large market, it essentially acquires or puts inplace
an expansion or growth option. This option, which will beexercised
only if future market developments turn out favorable
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Making Use of Real Options Simple 29
at a future date, but not otherwise, can oftentimes make a
seem-ingly unprofitable (based on passive NPV) base-case
investmentworth undertaking.
4. The option to contract. If market conditions turn out weaker
thanoriginally expected, management can operate below capacity
oreven reduce the scale of operations (by c%), thereby saving
partof the planned investment outlays (IC). This flexibility to
mitigateloss is analogous to a put option on part (c%) of the
base-scaleproject, with exercise price equal to the potential cost
savings(IC), giving max(IC cV, $0). The option to contract (just as
theoption to expand) may be particularly valuable in the case ofnew
product introductions in uncertain markets. The option tocontract
may also be important in choosing among technologiesor plants with
a different construction-tomaintenance cost mix,where it may be
preferable to build a plant with lower initialconstruction costs
and higher maintenance expenditures in orderto acquire the
flexibility to contract operations by cutting downon maintenance if
market conditions turn out unfavorable.
5. The option to temporarily shut down (and re-start)
operations.Actually, the plant does not have to operate (i.e.,
extract the min-eral) in each and every period automatically. In
fact, if mineralprices are such that cash revenues are not
sufficient to cover vari-able operating (e.g., maintenance) costs,
it might be better notto operate, temporarily. If prices rise
sufficiently, operations canstart up again. Thus, operation in each
year can be seen as acall option to acquire that years cash
revenues (C) by paying thevariable costs of operating (IV) as
exercise price, i.e., max(C IV,0). If switching costs (between the
operating and idle modes) aresubstantial, delays in switching may
arise (hysteresis). Optionsto alter the operating scale (i.e.,
expand, contract, or shut down)are typically found in natural
resource industries, such as mineoperations, facilities planning
and construction in cyclical in-dustries, fashion apparel, consumer
goods, and commercial realestate.
6. The option to abandon for salvage value. If the quantity of
re-serves turns out low, if mineral prices suffer a sustainable
decline,or if the operation does poorly for some other reason,
manage-ment does not have to continue incurring the fixed costs.
In-stead, management may have a valuable option to abandon
theproject permanently in exchange for its salvage value, that is
theresale value of its capital equipment and other assets in
second-hand markets. This option can be valued as an American
putoption on current project value with exercise price the salvage
or
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30 L. Trigeorgis
best alternative use value, entitling management to receive V
+max(A V, 0) or max(V, A). Naturally, more general-purposecapital
assets would have a higher salvage and option abandon-ment value
than special-purpose assets. Valuable abandonmentoptions are
generally found in capital-intensive industries, suchas in airlines
and railroads, in financial services, and in new prod-uct
introductions in uncertain markets.
7. The option to switch inputs or outputs. Suppose the
associatedmineral processing operation can be designed to use
alternativeforms of energy inputs (e.g., fuel oil, gas, or
electricity) to convertthe raw mineral into a variety of output
by-products. This wouldprovide valuable built-in flexibility to
switch from the current in-put to the cheapest future input, or
from the current output to themost profitable future product mix,
as the relative prices of theinputs or outputs fluctuate over time.
In fact, the firm should bewilling to pay a certain premium for
such a flexible technologyover a rigid alternative that confers no
or less flexibility. Indeed,if the firm can in this way develop
more uses for its assets rel-ative to its competitors, it may be at
a significant comparativeadvantage. Generally, process flexibility
can be achieved not onlyvia technology (e.g., by building a
flexible facility that can switchamong alternative energy inputs),
but also by maintaining rela-tionships with a variety of suppliers,
changing the mix as theirrelative rates change. Subcontracting
policies may allow furtherflexibility to contract the scale of
future operations at a low costin case of unfavorable market
developments. A multinationalcompany may similarly locate
production facilities in variouscountries in order to acquire the
flexibility to shift productionto the lowest-cost producing
facilities as the relative costs, otherlocal market conditions, or
exchange rates change over time. Pro-cess flexibility is valuable
in feedstock-dependent facilities suchas oil and minerals, electric
power, chemicals, crop switching,and supplier relationships in many
industries. Product flexibility,enabling the firm to switch among
alternative outputs, is morevaluable in industries such as
automobiles, consumer electron-ics, toys, or pharmaceuticals, where
product differentiation anddiversity are important and/or product
demand is volatile. Insuch cases, it may be worthwhile to install a
more costly flexiblecapacity to acquire the ability to alter
product mix or productionscale in response to changing market
demands.
8. Corporate growth options. As noted, another version of the
ear-lier option to expand, of considerable strategic importance,
iscorporate growth options that set the path of future
opportunities.
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Making Use of Real Options Simple 31
Suppose, in the above example, that the proposed
processingfacility is based on a new, technologically superior
process formineral refinement developed and tested internally on a
pilotplant basis. Although the proposed facility in isolation may
ap-pear unattractive, it could be only the first in a series of
similarfacilities if the process is successfully developed and
commer-cialized and may even lead to entirely new mineral
by-products.More generally, many early investments (e.g., R&D,
a lease onundeveloped land or a tract with potential oil reserves,
a strate-gic acquisition, or an information technology network) can
beseen as prerequisites or links in a chain of interrelated
projects.The value of these projects may derive not so much from
their ex-pected directly measurable cash flows, but rather from
unlockingfuture growth opportunities (e.g., a new-generation
product orprocess, related mineral reserves, access to a new or
expandingmarket, strengthening of the firms core capabilities or
strate-gic positioning). An opportunity to invest in a
first-generationhigh-tech product, for example, is analogous to an
option onoptions (an inter-project compound option). Despite a
seem-ingly negative NPV, the infrastructure, experience, and
poten-tial by-products generated during the development of the
first-generation product may serve as spring boards for
developinglower-cost or improved-quality future generations of that
prod-uct, or even for generating new applications into other areas.
Butunless the firm makes that initial investment, subsequent
genera-tions or other applications would not even be feasible. The
infras-tructure and experience gained can be proprietary and can
placethe firm at a competitive advantage, which may even
reinforceitself if learning cost curve effects are present. Growth
optionsare found in all infrastructure-based or strategic
industries, es-pecially in high tech, R&D, and industries with
multiple productgenerations or applications (e.g., semiconductors,
computers,pharmaceuticals), in multinational operations, and in
strategicacquisitions.
In a more general context, such operating and strategic
adaptability rep-resented by such a set of corporate real options
can be achieved at variousstages during the value chain, from
switching the factor input mix amongvarious suppliers and
subcontracting practices, to rapid product design andmodularity in
design, to shifting production among various products orcountries
rapidly and cost-efficiently in a flexible system or
multinationalnetwork.
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32 L. Trigeorgis
LESSONS AND IMPLICATIONS FOR FLEXIBLEDECISION MAKING
The insight gained from viewing investment opportunities through
a realoptions lens can be quite powerful. Real options analysis
provides a numberof insightful lessons and implications, summarized
below.
1. Uncertainty and flexibility are two key determinants of the
valueof an asset or firm. Their understanding calls for an
expandedvaluation criterion. The traditional valuation paradigm
based oncash flows from expected plans under the implicit
assumption ofpassive management has proven inadequate in dynamic
settings.The role of uncertainty in the presence of managerial
flexibility isnot necessarily penalizing, as conventional wisdom
would haveus believe. Greater variability of potential outcomes
around theexpected (mean) result may be beneficial in the presence
of op-tions and an asymmetric managerial position. Managerial
flexi-bility to revise future decisions when there are deviations
from theexpected plans introduces beneficial asymmetry in the
distribu-tion of project value returns by enabling upside
(value-creation)opportunities to be exploited fully while limiting
downside lossesby choosing not to proceed or abandon. The resulting
skewing ofthe probability distribution of expected project returns
towarda more positive outcome calls for an expanded (strategic)
NPVcriterion to also capture the additional value of managerial
op-erating flexibility and other strategic interactions:
Expanded (or Strategic) NPV = passive NPV+ Option Premium (ROV)
(Flexibility value+ Strategic value)
Based on this expanded criterion, it can be seen that it may
nowbe justified to accept projects with negative (passive) NPV
ofexpected cash flows (if this is offset by a larger option premium
orreal option value as a result of additional flexibility and
strategicvalue), or delay investment with positive NPV until a
later timewhen expanded NPV would be maximized under
uncertainty.
2. Managerial flexibility or real option value (ROV) may be
higher(other things the same) for firms or industries facing higher
un-certainty; for investment opportunities with longer horizons
orthat can be delayed longer; when (real) interest rates are
higher;or for multi-stage (compound) options.
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Making Use of Real Options Simple 33
3. Higher uncertainty tends to increase the value of the option
todefer (a single, irreversible, proprietary)
investmentprovidedthere are small or no early exercise benefits
(analogous to div-idends), strategic interactions or other embedded
options. Theflexibility to delay or wait and see enables acquiring
more orbetter information and making a more informed future
decision,potentially avoiding a mistake from premature investment
in casethings would develop unfavorably. This higher value to wait
andsee necessitates a higher critical investment threshold: the
crit-ical project value, V , must be at a significant premium
abovethe required investment cost, I , before it is justifiable to
investand sacrifice the option to wait. The implication of this is
thathigher uncertainty would presumably lead to investing less
orlater (other things the same), with potentially significant
macroe-conomic implications. I should caution, however, that this
holdsunder the provisional conditions made above (and relaxed
later)and may be different in different contexts, so it is
questionablewhether empirical studies on investment based on macro
datacan verify the presumed depressive role of uncertainty on
invest-ment (in terms of lower or delayed investment) if the
provisionalconditions are not confirmed to be carefully
satisfied.
4. If one can reverse a decision (with ease or little cost), it
is easierto make it (e.g., invest) in the first place. A
multinational cor-poration would find the decision to enter a new
foreign countryeasier if it can get out with limited damage in case
of unfavorabledevelopments. This principle holds in general
contexts beyondbusiness investment. For example, the decision to
get marriedmight be easier in societies where it is easier to
receive divorce(in Islamic parts of India men can obtain divorce
simply by pro-claiming the word 3 times). In deciding whether to
move fromthe United States to a smaller, more risky country, it
helps tomake the decision if one has U.S. citizenship rights. These
rightsgive the individual the option to reverse the decision and
operatein the best of the two countries over time, just as locating
plantsin several countries enables a multinational corporation to
op-erate in the best subset of several countries and shift
productionfrom one country to another to take advantage of
fluctuationsor differences in exchange rates, labor costs or other
productioninputs, tax regimes, etc.
5. Under uncertainty, it is prudent to stage an investment or
proceedwith decision plans in stages. Staging the investment or
decisionplans provides valuable flexibility to continue to the next
stage(receiving the option value from continuing) or to abandon
(exit)
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34 L. Trigeorgis
midway. Continuation (e.g., financing of subsequent stages
inventure capital) should be contingent on the success of
earlierstages.
6. Multistage opportunities may have significant growth
(com-pound) option value that may justify making strategic
invest-ments despite having negative NPV. Consider, for example,
atwo-stage growth option. The first stage involves investing in
amanufacturing facility in Spain to introduce a new product that
isexpected to generate moderate cash flows from the Spanish
mar-ket. The second stage would involve a 10-fold expansion into
thebroader European market 3 years later. The first-stage NPV ofthe
expected cash flows from investing in the Spanish marketis
negative, and committing now to enter the European marketon an
expanded scale seems ten times as bad. But the companydoes not have
to commit to European expansion now. Instead,it has an option to
wait and see how the Spanish and Euro-pean demand develops and
expand to the European market ifand only if it appears favorable to
do so 3 years from now. Theopportunity to expand in Europe, valued
as an option, may welloffset the negative NPV of the first-stage
investment (in effectthe option premium or exercise price that
needs to be paid toacquire the European expansion option) and can
justify makingthis strategic multistage investment on strategic
grounds. Em-pirically, companies in industries with higher
uncertainty thatinvolve multistage (compound) options tend to have
a higherproportion of their stock price deriving from growth
opportuni-ties (PVGO/P), providing an indirect confirmation of the
validityof real option theory predictions.
7. If investing would open up or create other options within
theproject (e.g., to later expand, abandon, or switch to
alternativeuses), then more uncertainty would also increase the
flexibilityvalue of these other embedded optionsincreasing the
value ofearly investing in the first place. For this reason (and
the otherreasons listed below), higher uncertainty would not
necessarilysuppress or delay investment.
8. In the presence of competition in an oligopoly setting, early
in-vestment may have strategic value by influencing the
equilibriumactions (quantity or price setting) of competitors in a
way ben-eficial to the investing firm or even by preempting
competitiveentry altogether in some cases. Thus, the option value
of wait-ing must be traded off against the strategic commitment
value ofearly investing. Again, the impact of higher uncertainty on
invest-ment is not clear-cut; in fact, it may not even vary
monotonically
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Making Use of Real Options Simple 35
with demand as shifts in demand may lead to shifts in the typeof
equilibrium games and different market structure outcomes(e.g.,
from a Nash duopoly to a Stackelberg leader/follower gameor a
monopoly) in different demand zones leading to value
dis-continuities as a function of demand. The value of the
strategicinvestment and the optimal competitive strategy (e.g., to
investnow or wait) depends on whether the resulting benefits of
theinvestment are proprietary or shared and whether they are
dam-aging or benefiting the competitor, as well as on whether
compet-itive reaction is expected to be contrarian (opposite to the
actionof the investing firm) or reciprocating (similar to the
action ofthe investing firm). When the investment benefits are
proprietaryand the pioneer can get stronger at the expense of its
competitor,it should commit to an early investment (aggressive)
strategy ifthe competitors reaction is contrarian; e.g., if it will
retreat andcut its market share under quantity competition as the
pioneerexpands its own market share. However, when the benefits
areshared, thereby benefiting the competitor as well, and a
contrar-ian competitor would respond aggressively, taking advantage
ofthe pioneers accommodating position, the firm should follow
aflexible wait-and-see strategy rather than subsidizing an
aggres-sive competitor while itself paying the full cost. The above
canbe reversed under reciprocating (price) competition. If the
bene-fits are shared and will benefit a competitor who will
reciprocatewhen treated nicely (e.g., by maintaining high prices)
the optimalstrategy might be to invest early (but not
aggressively). On thecontrary, if the benefits are proprietary and
will hurt a competi-tor who will retaliate by entering into a price
war, it may makebetter sense to wait or not invest.
9. Competitive pressure may induce firms (e.g., in a winner
takesall innovation race) to invest prematurely, resulting in a
subop-timal prisoners dilemma situation. Each of the two firms
(likeprisoners), being afraid that it may be preempted by the
otherand lose all (the most severe punishment), would rush to
investprematurely (give in), rather than wait (hold out), which
maybe the preferred outcome. A joint research venture may enablethe
two firms to more fully appropriate the flexibility value
fromwaiting (avoiding the prisoners dilemma) by coordinating
andjointly optimizing against demand uncertaintybesides sharingand
saving on the investment cost. A limitation is that, in
col-laborating, a firm gives up the possibility to outwit its
rivals andgain a competitive advantage or strategic value over the
otherfirm.
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36 L. Trigeorgis
10. Multiple options embedded in a project may interact; i.e.,
optionvalue additivity may break down. The presence of a later
optionenhances the value of the underlying asset for a prior
option,while exercising an earlier option may alter the scale of
(and inthe case of the option to abandon, may extinguish) a later
option.The value of a portfolio or combination of embedded
optionstypically is less than the sum of separate or independent
optionvalues. Therefore, using an analytic formula like
Black-Scholesto determine the values of separate options and then
add themup may be misleading. The error from adding up separate
optionvalues may be of the same order of magnitudebut in the
op-posite directionas the error from ignoring options
altogether.That is, a wrongly executed options analysis can be as
dangerousas a nave NPV analysis.
11. Options to switch (among the cheapest of several inputs,
best ofseveral outputs, or most profitable countries of operation)
pro-vide valuable flexibility and risk management value.
Traditionalmean-variance portfolio theory based on the notion that
risk isundesirable and must therefore be minimized (for a given
ex-pected return) is inadequate; it needs to be extended for
portfo-lios of (potentially interdependent) options, incorporating
highermoments. The flexibility to adjust plans when deviating
fromexpectations by improving the upside potential while
limitingthe downside risk adds asymmetry or skewness (third
moment),while potential volatility dependence on project value,
competi-tive jumps, and technological disruptions may introduce fat
tailsand kurtosis (fourth moment). The very notion and role of
riskmust also be revisited when flexibility is present. With
optionsto choose the best of several alternatives (or on the
maximum orminimum of several assets) or options to switch from one
modeof operation or being to another, lower correlation tends to
in-crease the relative volatility and option value of a flexible
systemor network. When the value of one alternative drops, an
option tochoose the best or switch to another alternative is worth
more ifthe value of that second alternative tends to increase (that
is, if ithas negative correlation with the first). For this reason,
multina-tional corporations (MNCs) operating in several countries
wouldprefer to select the next strategic location (to be added to
theirmultinational network portfolio) to have lower correlation
(withthe existing structure), not so much in order to diversify and
re-duce risk, but rather in order to increase the relative
volatilityand option value of the flexible network. Risk is not
necessarilysomething to be avoided or be penalized for, but rather
can be
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Making Use of Real Options Simple 37
seen as a window of opportunity for the more flexible and
in-novative corporations to create more value by leveraging
theiropportunity choices while limiting losses.
12. When switching among operating modes or strategies,
thepresence of significant switching costs (e.g., to enter, exit,
orshut down) may induce a hysteresis, inertia or delay/lag ef-fect.
Even though immediate switching may be attractive basedon
short-term cash-flow considerations, it may be long-term op-timal
to wait, e.g., due to a high switching cost or probabilityof
switching back later. Examples involving hysteresis effects
in-clude continuing operations of a currently unprofitable mine
oroil field despite temporarily suppressed prices; the Japanese
autoproducers who, once they entered the U.S. market in
profitabletimes, kept hanging on in the United States despite
incurringlosses in subsequent years; lags in hiring and firing by
compa-nies as business moves to an up and down cycle; and delays
inseeking divorce despite an unhappy marriage. All these
casesinvolve irreversible or costly-to-reverse decisions that
justify de-laying a switching decision for a while since a
re-switch back tothe current situation is either infeasible or
would occur only aftera costly impairment of infrastructure,
goodwill, etc.
MODULAR STRUCTURING AND SIMPLIFYING OF COMPLEXREAL OPTION
PROBLEMS
Most real-life problems involve more complex combinations of the
above(and occasionally other) options. However, one can simplify a
complexinvestment decision problem structure by decomposing it into
a few basicbuilding-block option types (such as the standard
options in the previoussection) connected by some basic decision
operations. Figures 1AD re-view some basic or common types of real
options. In the figures, optionsare illustrated with a hexagonal
symbol, shown in the second column, withthe relevant payout shown
at the bottom depending on option type (e.g.,C + V for a call
option; for shorthand, the max( , 0) is implied by theoption symbol
itself and is omitted). A hat () over the investment costto be paid
(C) or the (gross) PV of project cash flows (V ) indicates thatthey
are uncertain (stochastic). The third column in Figure(s) 1
presents arelevant authors analytic model (e.g., Black-Scholes for
the call option towait in Figure 1A). The last column lists actual
case applications (mostlyfrom the authors experiences) most
appropriate for that type of option.Figure 1A reviews the options
to wait (call on project value V ) and to ex-pand (call on e% of V
) using the Black-Scholes [7] formula (on V or eV ,
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38 L. Trigeorgis
Figure 1A. Basic/common option types.
respectively), to abandon or contract (put on c% of V), and
Margrabes [30]option to exchange or switch one asset for another
(here cost C for projectvalue V). Figure 1B focuses on compound
options, including the simplecompound (or pure growth) option by
Geske [12], sequential two-stage
Figure 1B. Basic option types: Compound options.
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Making Use of Real Options Simple 39
Figure 1C. Basic option types: Max options.
compound exchange option, and an N -stage compound exchange
op-tion representing a numerical generalization of the above.
Figure 1Creviews options involving the max, including the Stulz
[45] and John-son [18] models on European options to pay cost C by
a given maturity to
Figure 1D. Basic option types: And options.
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40 L. Trigeorgis
acquire the max of two or more assets, and the generalized max
(OR)operator on the best of 2 or more option alternatives (e.g.,
applicable inanalyzing the choice among the best of two product
standards, the digitaland analog, in the case of Philips
Electronics). Combinations of the abovetypes of options and their
possible interactions leading to non-additivityof separate option
values are discussed in Trigeorgis [53]. Figure 1D il-lustrates
basic AND type options. They include the sum of N parallel
(orstrategically independent) options shown vertically, such as
expanding ge-ographically in continents A, B, and C or introducing
new services D, E,and F, each involving the right to pay
(stochastic) cost Ci by time ti toacquire underlying asset value Vi
(i = 1, . . . , N ). They also include mod-eling manufacturing
operations of a plant (e.g., Shell Chemicals flexibleplastic
manufacturing plant) as the sum of T European operating
optionsacross time (shown horizontally), provided switching costs
are negligible.Each year of operation may be modeled as a European
option to exchangea variable operating cost (C) for the value of
generated cash flows (V ),using the Margrabe option to exchange one
asset for another, or as an op-tion to incur the variable cost (C)
to obtain the maximum revenue fromproducing the best of two (or
more) products, using the Stulz or Johnsonoptions on the maximum of
several assets. In general, this approach mayaccommodate a generic
option payout of the form cC + aV 1 + bV 2 +function (V 1, V 2. . .
) where C , V 1, V 2, . . . can be uncertain (stochastic)variables
and constants a, b, c can be of any sign. Such generic
options(hexagons) can occur in any combinations over multiple
stages, connectedwith one or more of four basic decision operators
(with the OR, AND, AVGoperators shown in squares), to represent the
basic option structure of mostreal life problems.
The four basic decision operations commonly encountered are
illus-trated in Figure 2. They involve (a) the choice of the best
among sev-eral mutually exclusive alternatives (OR or MAX); (b) the
sum of several(parallel or strategically independent) options
(AND); (c) the probabilisticaverage (AVG) of several follow-on
options across various technical sce-narios weighted by their
corresponding actual probabilities, or investingin a portfolio
(weighted average) of several technological or other op-tions by
allocating a portion of a given budget in each of these options;and
(d) recursive multistage or compound/sequential options (COMP)
thatmay provide not only their own cash flows but also provide
follow-onoptions. In all the above basic decision operators, both
the cost of ex-ercising an option (C) and the present value of
resulting project cashflows (V ) may be uncertain. Although Figure
2 illustrates decision oper-ators involving 2 decision branches or
two stages, these are readily ex-tended to N decision branches or
to N stages (as illustrated in subsequentfigures).
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Making Use of Real Options Simple 41
Figure 2. Basic decision operations.
Valuation would proceed in a recursive (even modular) manner
startingfrom the end and moving backward following the standard
risk-neutraloption valuation procedure. Figure 3A illustrates a
standard basic problemstructure (combination of standard options
and decision operators) for tworeal-life applications taken from
two entirely different industries. The en-ergy industry case
involves a staged power plant construction with optionsto abandon
midstream and later expand. The pharmaceutical industry
caseinvolves valuing R&D during the clinical trials phase and
determining thevalue of the patent rights for a new drug (also
involving options to aban-don and to expand into a related niche).
The basic problem structure andrelated option maps look remarkably
similar, despite differences in prob-lem context and industry
characteristics. In both situations each firm facesa compound
(COMP) or multistage option to start (in an early stage) andthen
complete (at a later stage) a development process (building a plant
orcompleting clinical trials), followed by an option on the best
alternative(OR), either to continue with commercial production
operations (also in-volving a later option to expand) or to abandon
for a salvage or sale value.Since the interim decision on the
option to complete development/continueor abandon partly depends on
the value of the subsequent option to laterexpand, that option must
be determined first, starting from the end, andthen used in the
backward valuation process along the way to make theearlier choice
(to continue or abandon) in the previous step, and so on.
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42 L. Trigeorgis
Figure 3A. Similar basic structure from different industry
applications.
Figure 3B. Details on Glaxo case application.
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Making Use of Real Options Simple 43
Figure 4. Eli Lilly case application problem structure.
Figure 3B illustrates the problem structuring option map for the
abovepharmaceutical case (Glaxo) with more details on the timing,
staged costs,base project value (present value of cash flows from
launching the oralversion of the drug), expansion costs and
factors, salvage (sell) value, etc.
Figure 4 illustrates the problem structuring for another
pharmaceuticalcompany (Eli Lilly), involving a committed decision
to launch a basicversion of a drug (PTCA) and options to pursue two
extensions (AMI andAngina). As shown in the top figure, the second
drug extension (AMI) maybe introduced alone or following the first
extension (Angina), in which caseit may benefit from both
structural synergies (since the decision to launchAMI would benefit
from prior knowledge of the success of the precedingAngina
introduction) as well as from economic synergies (as the costs
ofconvincing doctors of the benefits of the AMI extension would be
lower,and the market expansion factor higher, following prior
introduction ofAngina). The lower figure casts the above managerial
decision problem asinvolving the choice between a sequential
(compound option) vs. a parallel(sum of independent options)
marketing expansion strategy.
Figure 5 illustrates the problem structuring for two HBS case
appli-cations involving probabilistic options (AVG). In the Arundel
case (toppanel), the success of a first movie will be revealed in
the theatres by year1 with probability p, leading to an (call)
option to make a sequel moviewithin the subsequent 2 years. In the
Antamina case (lower panel), the
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44 L. Trigeorgis
Figure 5. Probabilistic (AVG) case applications.
winner of a government bid will have 2 years to decide whether
to incurthe development cost, C2, to receive the value of copper
and zinc reserves,V , which depends on the stochastic copper and
zinc prices (Pc, Pz). Theprobabilities of high (H), medium (M) and
low (L) reserves, accountedfor through the AVG decision operator,
would weigh the resulting optionvalues conditional on finding high,
medium, or low reserves in year 2.
Figure 6A illustrates use of the AND operator to access the
growthoption value of a high-tech IPO. Tiscalis existing business
at the timeof the IPO was only fixed-line telephony, but its
management envisionedplans to first offer e-commerce services in
Italy and then expand them in
Figure 6A. Tiscali (AND) case application: Growth option value
of high-tech IPO.
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Making Use of Real Options Simple 45
Figure 6B. Details on Tiscali case application.
the broader European market (a compound option). It also
expressed plansto acquire a UMTS license that would enable it to
offer integrated 3rdgeneration mobile services. More details on
Tiscalis problem structuringand option map are given in Figure 6B.
Figure 7 illustrates the optionmap for staging network (NW)
infrastructure for a leading UK telecomoperator. Each staged
network investment (e.g., NW1) provides the sumof 3 options: (a)
expand by acquiring new business clients by the way thenetwork
would be physically laid out, (b) switch customers initially using
alow-bandwidth technology to a high-bandwidth one, and (c) proceed
to thenext stage (NW2), involving similar such options, and so on.
The readercan appreciate that there is no analytic, closed-form
solution or an easymodeling approach for such problems, but they
can readily be handledthrough the recursive and modular structure
proposed herein.
PAST AREAS OF APPLICATION
Besides theoretical developments, real option applications have
been re-ceiving increased attention. Real options valuation has
been applied in avariety of contexts, such as in natural resource
investments, land devel-opment, leasing, flexible manufacturing,
government subsidies and regula-tion, R&D, new ventures and
acquisitions, foreign investment and strategy,
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46 L. Trigeorgis
Figure 7. Telecom case application problem structure: Staging
network(NW) infrastructure.
and elsewhere. The review below is just indicative and is in no
way meantto be exhaustive or capture all the important
contributions.
Natural Resource Investments
Early applications naturally arose in the area of natural
resource invest-ments due to the availability of traded resource or
commodity prices, highvolatilities, and long durations, resulting
in higher and better option valueestimates. Brennan and Schwartz
[8, 9] utilize the convenience yield de-rived from futures and spot
prices of a commodity to value the optionsto shut down or abandon a
mine. Paddock, Siegel, and Smith [37] valueoptions embedded in
undeveloped oil reserves and provide empirical ev-idence that
option values are better than actual DCF-based bids in valu-ing
offshore oil leases. Trigeorgis [50] values an actual minerals
projectconsidered by a major multinational company involving
options to cancelduring construction, expand production, and
abandon for salvage. Bjerk-sund and Ekern [5] value a Norwegian oil
field with options to defer andabandon. Morck, Schwartz, and
Stangeland [36] value forestry resourcesunder stochastic
inventories and prices. Laughton and Jacoby [27] exam-ine biases in
the valuation of real options and long-term decision makingunder a
mean-reversion price process. Kemna [20] shares her experienceswith
Shell in analyzing actual cases involving the timing of developing
anoffshore oil field, valuing a growth option in a manufacturing
venture, andthe abandonment decision of a refining production
unit.
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Making Use of Real Options Simple 47
Land Development
Titman [47], Williams [57], and Quigg [40] show that the value
of vacantland should reflect not only its value based on its best
immediate use (e.g.,from constructing a building now), but also its
option value if develop-ment is delayed and the land is converted
into its best alternative use inthe future. It may thus pay to hold
land vacant for its option value even inthe presence of currently
thriving real estate markets. Quigg [39] reportsempirical results
indicating that option-based land valuation that incorpo-rates the
option to wait to develop land provides better approximations
ofactual market prices. In a different context, McLaughlin and
Taggart [35]view the opportunity cost of using excess capacity as
the change in thevalue of the firms options caused by diverting
capacity to an alternativeuse. Grenadier [14] developed a model of
real estate development, offeringan explanation for observed market
behavior in land development, such asoverbuilding.
Flexible ManufacturingThe flexibility provided by flexible
manufacturing systems, flexible produc-tion technology, or other
machinery having multiple uses has been analyzedfrom an options
perspective by Kulatilaka [24, 25], Triantis and Hodder[48],
Kulatilaka and Trigeorgis [26], and Kamrad and Ernst [19],
amongothers. Kulatilaka [25] values the flexibility provided by an
actual dual-fuelindustrial steam boiler that can switch between
alternative energy inputs(natural gas and oil) as their relative
prices fluctuate, and finds that the valueof this flexibility far
exceeds the incremental cost over a rigid, single-fuelalternative.
Baldwin and Clark [2] study the flexibility created by modular-ity
in design that connects components of a larger system through
standardinterfaces.
Leasing Contracts
Copeland and Weston [10], Lee, Martin, and Senchack [28],
McConnelland Schallheim [33], and Trigeorgis [54] value various
operating optionsembedded in leasing contracts. Grenadier [13] uses
real options to developa model that can be used to price different
types of leasing contracts.
R&D/Innovation
Kolbe, Morris, and Teisberg [23] discuss option elements
embedded inR&D projects. Option elements involved in the
staging of start-up ventures
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48 L. Trigeorgis
are also discussed in Sahlman [41] and Willner [58]. Grenadier
andWeiss [15] examine the situation in which a firm has projects
that involvesequential innovation. Their valuation incorporates the
learning that assiststhe valuation and decision-making pertaining
to future innovations.
Security Analysis
Real options have been advocated as an approach to valuing
companies insecurity analysis. For example, Mauboussin [32]
discusses how real optionsvaluation can be used to supplement
traditional valuation approaches. Hesuggests that real options
valuation is particularly useful in valuing com-panies that are
R&D intensive as well as Internet companies. Kester
[21]estimates that the value of a firms growth options is more than
half themarket value of equity for many firms, even 7080% for more
volatileindustries. Similarly, Pindyck [38] suggests that growth
options representmore than half of firm value if demand volatility
exceeds 20%. Berger et al.[4] empirically access investors
valuation of the abandonment option.
Foreign Investment
Baldwin [1] discusses various location, timing, and staging
optionspresent when firms scan the global marketplace. Bell [3],
and Kogut andKulatilaka [22], among others, examine entry,
capacity, and switching op-tions for firms with multinational
operations under exchange rate volatility.Hiraki [17] suggests that
the Japanese bank-oriented corporate governancesystem serves as the
basic infrastructure that enables companies to jointlydevelop
corporate real options.
Other Applications
Strategic acquisitions of other companies also often involve a
number ofgrowth, divestiture, and other flexibility options, as
discussed by Smith andTriantis [44]. Luchrman [29] discusses
viewing strategy as a portfolio ofreal options. Smit and Ankum [42]
and Smit and Trigeorgis [43] proposea game-theoretic approach to
corporate investment strategy. Mason andBaldwin [31] value
government subsidies to large-scale energy projects asput options,
whereas Teisberg [46] provides an option valuation analysis
ofinvestment choices by a regulated firm. Various other option
applicationscan be found in areas ranging from shipping [6] to
environmental pollutionand global warming (e.g. [16]). The
potential for future applications itselfseems like a growth
option.
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Making Use of Real Options Simple 49
RESEARCH CHALLENGES AHEAD
Despite significant progress in recent years, some long-standing
gaps andchallenges remain. Here is a list of challenging issues
that future researchmust still address:
1. Studying more actual case applications and tackling real-life
im-plementation issues and problems.
2. Studying investments (such as in R&D, pilot or market
tests, orexcavations) that can generate information and learning
(e.g.,about the projects prospects) by extending/adjusting
optionpricing and risk-neutral valuation.
3. Exploring in more depth endogenous competitive
counterac-tions and a variety of competitive/market structure and
strategicissues using a combination of game-theoretic industrial
organi-zation with option valuation tools.
4. Better modeling of the various strategic and multistage
growthoptions.
5. Extending real options in an agency context recognizing that
thepotential (theoretical) value of real options may not be
realizedin practice if managers, in pursuing their own agenda
(e.g., ex-pansion or growth, rather than firm-value maximization),
misusetheir discretion and do not follow the optimal exercise
policiesimplicit in option valuation. This raises the need to
design properincentive contracts by the firm (taking also into
account asym-metric information) and develop a more dynamic,
option-basedextension of economic value added.
6. Better recognizing that real options may interact not only
amongthemselves but with financial flexibility options as well, and
un-derstanding the resulting implications for the combined,
inter-dependent corporate investment and financing decisions.
7. On the practical side, applying real options to the valuation
offlexibility in related areas, such as in competitive bidding,
infor-mation technology, or other platform investments,
internationalfinance options, and so on.
8. Using real options to explain empirical phenomena that
areamenable to observation or statistical testing, such as
examiningempirically whether the management of firms that are
targets foracquisition may sometimes turn down tender offers in
part due tothe option to wait in anticipation of receiving better
future offers.We also need more empirical studies to confirm other
qualifiedpredictions of options theory, such as the impact of
uncertaintyon investment.
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50 L. Trigeorgis
9. Doing more field or survey studies to test the conformity of
the-oretical real option valuation and its implications with
manage-ments intuition and experience, as well as with actual data
whenavailable.
10. Developing a more credible general portfolio theory for
(pos-sibly interdependent) options under budget or other
constraintsthat recognizes the potentially beneficial role of
uncertainty inthe presence of flexibility to select the best subset
among alterna-tive options. Finally, applying this to address
important strategicportfolio problems in various contexts, such as
management of aportfolio of start-up ventures by a venture
capitalist, developmentof a pipeline portfolio of R&D
opportunities by a pharmaceu-tical company, or selection of a
subset of technologies to investin by a telecom company, and
dynamic revision of the subset ofinvested technologies as
uncertainties and their relative meritschange over time.
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BIOGRAPHICAL SKETCH
LENOS TRIGEORGIS is the Bank of Cyprus Chair Professor of
Finance at the Universityof Cyprus ([email protected]). He is also
President of the Real Options Group (www.rogroup.com). He
previously taught at Boston University, Columbia University, and
theUniversity of Chicago. He holds a Ph.D. (DBA) from Harvard
University. He publishedwidely in numerous journals on corporate
finance, competition and strategy, and has writ-ten a number of
books on real options with MIT Press, Oxford University Press,
PrincetonU. Press, and others. He is internationally known as the
author of Real Options (recentlytranslated in Japanese), which is
considered path-breaking for the field. He recently also pub-lished
a co-authored book, Strategic Investment. His consulting
experiences include BritishPetroleum, the Fiat Group, Cable &
Wireless, Swisscom, Andersen Consulting/Accenture,Ernst &
Young, Morgan Stanley, and the U.S. government.