Which book should relate to learning options

Investment decision based on the real option approach

Table of Contents

1. Introduction

2. Investment evaluation process
2.1. Traditional investment appraisal practices
2.2. Real option approach
2.3. Transfer of financial option models to real options

3. Categorization of real options
3.1. Growth option
3.2. Reduction option
3.3. Learning option
3.4. Complex real options

4. Evaluation of real options
4.1. Binomial model
4.2. Black-Scholes model

5. Assessment of the real options approach and outlook ..

List of figures

Figure 1: Categories of real options

Figure 2: Binomial tree for a multi-period scenario

Figure 3: Uncertain project values ​​over time

Figure 4: Value of the real option over time

1. Introduction

The evaluation of investments is an indispensable subject in business administration. The strategic planning, management and success of a company depend on reliable investment planning in order to differentiate between economically advantageous and non-advantageous investments.[1]

In practice, various valuation approaches that determine the value of a future investment are widespread as a decision-making aid for the selection of profitable investments. The traditional valuation methods are based on an analysis of the expected cash flows from the investment. This does not take into account strategic room for maneuver or the possibility of adapting or canceling an investment due to a new level of information during the term. But especially in times of volatile and uncertain markets as well as shorter development times for new technologies, it is essential for companies to react flexibly to new framework conditions and to adapt the investment projects that have already been made.

In order to incorporate an assessment of the possible alternative courses of action and strategic aspects into the investment decision, the traditional approach is expanded to include an assessment of the existing flexibility ("real option"). In this way, more precise investment assessments are obtained, especially in an uncertain investment environment that includes a large amount of room for maneuver, and thus more reliable decision-making templates for management are achieved.

In the context of this thesis, the evaluation approach of the real options is presented.

Starting in Chapter 2 with a presentation of the traditional valuation approach of an investment based on the capital value, this is expanded in the following to include the action option value (real option value).

In the following chapter 3, the categories of real options are presented, which include growth, reduction, learning options and complex real options.

Then, in Chapter 4, the most widespread valuation approaches for real options, the binomial model according to Cox / Ross / Rubinstein and the Black-Scholes model, are presented and explained using an example.

This seminar paper closes with an assessment of the real options approach and an outlook in Chapter 5.

2. Investment evaluation process

In this chapter the approach of the real option valuation is arranged in the context of the investment valuation procedure and the theoretical principles are explained.

2.1. Traditional investment appraisal practices

There are various methods of determining an investment value. While the static methods of the investment calculation characterize a one-period consideration, the dynamic methods take into account a multi-period analysis of the payment flows of the investment project over the entire investment period. The former include the cost comparison, profit comparison, profitability comparison or amortization calculation. The dynamic methods include the internal rate of return, annuity or capital value method, among others. These approaches are based on the investigation of the future expected positive and negative cash flows of the investment, which are discounted at the time of the decision in order to obtain the present value of the investment.[2]

The net present value method, also known as the discounted cash flow method (DCF method), calculates the present value "Net Present Value" (NPV) of an investment by discounting the future payment surpluses not included in this excerpt.[3]

Figure not included in this excerpt

For a positive NPV there is a return for the investor from his invested capital, which exceeds the interest in the amount of the discount factor. In addition to the risk-free interest rate, the discounting factor also includes a risk premium that is constant over the entire duration of the project, depending on the uncertainty of the expected cash flows.[4]

The criticism of the DCF method lies in the static consideration of the future cash flows, because it is assumed that the investment is held exclusively passively by management and that there is no room for maneuver or flexibility during the investment period.[5]

2.2. Real option approach

The approach of the real options is based on the criticism of the DCF method and takes into account in its evaluation the possibilities for active control of the investment project "by exploiting opportunities and avoiding risks"[6]. This also includes obtaining additional rights (e.g. patents, concessions) in order to be able to react to the production and sales process.[7] This entrepreneurial flexibility represents a “real option” that is available to management and therefore has to be included in an investment decision as relevant for valuation.[8]

The approach of the real options expands the discounted cash flow method by an additional value contribution, which arises from the existing flexibility.[9] In simplified terms, the extended investment value can thus be viewed as the sum of the capital value calculated from the DCF method and the option value achieved from the investment or the measured scope for action and expressed in the following formula:[10]

Figure not included in this excerpt

For situations where there is no room for maneuver, the valuation using the DCF method and the real options approach will achieve the same result.[11] The use of real options therefore only makes sense in an environment of high uncertainty, high flexibility of action and rapidly changing markets.[12]

2.3. Transfer of financial option models to real options

As already mentioned, (real) options for action are available to management. When evaluating these real options, use is made of the financial option valuation from the area of ​​financial markets and the associated option price models.[13]

A finance option includes a certain right for its owner, but not the obligation to exercise this option during the term (American option) or at the end of the term (European option).[14] A distinction is made between a purchase option ("call option"), i.e. the right to buy at a specified price, and a sell option ("put option"), i.e. the right to sell at a specified price.[15]

If the model of the financial options is transferred to the real options, then a real option contains "the right, but not the obligation, to carry out a certain action for a certain period of time and at certain costs"[16].

3. Categorization of real options

The real options, i.e. the right to choose to exercise a certain action, can be systematized into different categories, depending on the underlying choice.

In the literature there are various differentiations of the real options, which in principle, however, are not mutually exclusive. In the following, a separate classification (as illustrated in Figure 1) is presented, which is made up of different literature sources.

Figure not included in this excerpt

Figure 1: Categories of real options[17]

3.1. Growth option

The growth option includes the possibility of entering into a new investment (entry option), continuing an existing investment (continuation option) or expanding and expanding an existing investment (expansion option).[18]

All three possibilities assume a positive development of the investment with the prospect of an expansion and enlargement of the investment project, i.e. to develop "new profit potential through investments and follow-up investments (follow-up projects)"[19]. This is comparable to a purchase option in the field of financial theory.

The option to enter new markets can be cited as an example of a growth option or entry option. For example, if a foreign bank takes over a small domestic bank, there are no synergies associated with it for the time being, but the opportunity for further expansion of the domestic business is acquired.[20] The option has a particularly high value if there are entry barriers for the market to be developed.[21]

[...]



[1] See Becker (2009), p. 38.

[2] See Becker (2009), p. 41ff.

[3] See Baecker, Hommel, Lehmann (2003), p. 19.

[4] See Baecker, Hommel, Lehmann (2003), p. 19.

[5] See Brealey, Myers, Allen (2006), p. 597.

[6] Ernst, Schneider, Thielen (2003), p. 238.

[7] See Schacht, Fackler (2009), p. 366.

[8] See Schacht, Fackler (2009), p. 361.

[9] See Emmert (2001), p. 5.

[10] See Hilpisch (2006), p. 38.

[11] See Schacht, Fackler (2009), p. 361.

[12] See Baecker, Hommel, Lehmann (2003), p. 23.

[13] Cf. Krolle, Oßwald (2003), p. 178. The transferability of financial options to real options is only possible under certain premises, which are not discussed in more detail in this seminar paper, cf. Krolle, Oßwald (2003), p. 178.

[14] In the following, a European option is assumed, i.e. an option that can only be exercised at the end of the term.

[15] See Brealey, Myers, Allen (2006), pp. 542ff.

[16] Schacht, Fackler (2009), p. 365.

[17] Own representation. Based on: Ernst, Schneider, Thielen (2003), p. 219.

[18] See Ernst, Schneider, Thielen (2003), p. 218.

[19] Kunz (2007), p. 132.

[20] See Leithner, Liebler (2001), pp. 137-138.

[21] See Schacht, Fackler (2009), p. 367.

End of the reading sample from 21 pages