Capturing value with real options: improving the quality of managerial decision making and firm performance by formally building the value of real options into investment evaluation.(EDUCATION SUPPLEMENT)

Publication: Journal of Banking and Financial Services

Publication Date: 01-AUG-05

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COPYRIGHT 2005 Australian Institute of Banking and Finance

Managerial decisions--which are generally made within the context of uncertainty about future developments and instability in the business environment--have a high rate of failure. It is, therefore, a natural response for managers to be wary of data provided to support decisions, to delay commitment until returns are certain and to maximise flexibility for future actions.

From a financial perspective, these behaviours emerge, respectively, as: a high discount rate relative to the apparent risk of a project or investment; preference for immediate benefit or gratification; and value attributed to any optionality associated with a decision.

In short, managers who cannot secure an immediate payout will prefer courses of action with attached options. This is an intuitive response that is all too infrequently valued and measured. Thus we believe that a Real Options framework can add rigour and structure to decisions by investors and managers.

Real options versus financial options

An option is a contract that can be enforced at the holder's discretion. The contract will have key terms such...

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