Taxonomy of Real Options

The taxonomy of real options tells whether the real options are shared or proprietary. It also states if the real options are compounded or simple and the option-decision expiration can be postponed or not. The taxonomy of real options is based on the flexibility of the real options.
The various differentiations between the several real options include swapping of use, deferring investment, staging of investments, changing the levels of investment, enhancing the level of investment or abandoning the investment. The analysis of real options is used to evaluate the decisions of capital budgeting.

In order to maximize the value of a firm, the managers need to compare the internal capacity of the firm in relation to the opportunities it is getting and then take the decisions regarding the investment of the firm accordingly. Real options are the chances given to the managers depending on the flexibility they enjoy over the timing of decisions. The real options are considered as the right to take the decision of capital investment options.
An example of real option is that if the business wants to invest for the expansion of the business, then this opportunity is a real option.
The concept of real options is opposite to that of financial options because the real option cannot be sold. For the case of the given example, owner of the firm can take the decision of expanding his business but cannot sell his right of expansion to another party. The real option concept is relatively newer than that of financial options. Professor Stewart Myers was the first person to develop the term ‘real options’.

With the analysis of real options, the uncertainty involved in the projects is determined and calculated by the risk-adjusting chances. Then the decision of discounting the cash flows at a rate that is free from risk can also be taken. The approach of real options analysis actually drives the decision takers to be more rational to judge the assumptions that they are considering for their projects.

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Last Updated on : 27th June 2013

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