Real option analysis is a refinement of the discounted cash flow model, which gives important insight into the value creation and timing of future business decisions. The discounted cash flow method is one of the most widely recognized and applied models to value projects and companies, but unfortu-nately it has a number of weaknesses especially with regard to uncertainty and the possibility of later alterations by management. Real option analysis improves the static valuation from the discounted cash flow model by combining it with the financial option pricing models, in a way that takes into account the probabilistic nature of the projects cash flow and management’s flexibility to act upon changes in the business environment. Real options can be valued using multiple financial option pricing models, but since the binomial model is the most flexible of the bunch, it is has become the most applied. Real options appear in uncertain projects, where the uncertainty can somehow be solved over time, and management has the ability to react on any new information concerning the project. The most common simple real options include the option to abandon, expand, contract, wait and of course choose between two or more of the aforementioned. The simple options is however not always advanced enough to replicate the com-plexity of most projects, and thus real option analysis uses compounded options instead. Strategic planning and investment is an explicit recognition, development and management of its portfolio of real options. A big part managing the portfolio correctly is to restrain from exercising the real options prematurely, even though it might be tempting from time to time. There is six different regions real options can be in, and depending on the region it can be determined how best to address them. Real options in region 1 and 6 are the easiest to manage because they have little or no time left to expiration, and therefore they should be exercised “now” and “never” respectively. It is a lot harder to determine what to do in region 2 to 5, since the real options still have time and uncertainty left before management must make a final investment decision. Thus in region 2 and 3 management are to invest “maybe now” and “probably later”, and in region 4 and 5 they will only “maybe later” and “probably never” exercise the real options. One of the big advantages of evaluating real options in relation to the six regions is that it makes it easier to illustrate the effect real options has on each other, and how they react on changes in the business environment. Management should have a holistic ap-proach to handling synergies between projects, in order to create a strategy, which creates an optimal balance between strategic and operational activities, so the company benefits now and generates enough growth options to profit in the future as well.
|Educations||MSc in Finance and Accounting, (Graduate Programme) Final Thesis|
|Number of pages||115|