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Real Options Theory and the Handling of Giga-Investments

Submitted by Christer Carlsson, 18.12.2001, IBA E

Problem

Very large investments, often called giga-investments, require a budget of 0.2-0.5 Bł and will typically have a life cycle of 15-25 years. The classical approach for decision support is to estimate the future cash inflows of the products (or services) produced through the investment, the future cash outflows caused by the investment and related operations and then to calculate the net present value (NPV) of these cash flows. If the NPV is significantly positive the investment decision is made and senior management will have to live with this decision for the life cycle of the giga-investment. In many cases this have been problematic, in some cases catastrophic.

Solution

The Black-Scholes formula for setting the optimal price of an option in the financial market won a Nobel Prize in 1990s. Less known is the version of the formula, which was developed by Merton for real assets in the 1970s. The real options model offers a way to handle large investments with risky outcomes in a more flexible way than the NPV method. There is an option for senior management to invest capital or to wait for more and better information, and then commit capital. This works out as a decision tree spanning most of the life cycle of the giga-investment and which makes it possi-ble to make decisions on investment as milestones in future markets are passed. The flexibility offered has been shown to save significant costs and to reduce the possibil-ity of building (a very expensive) catastrophe.

Status and results

The real options models have been tested on fours historic cases and been evaluated and compared with the results produced with the NPV methods. In all four cases the costs, which could have been saved with the real options methods were significant and it was possible to show that some bad decisions could have been avoided. The models were implemented with MS Excel and run in simple client-server environ-ments at very low cost.

Adaptivity and portability

The real options methods adapt to changing market conditions if the decision tree is made dynamic, i.e. it is allowed to change its structure on the basis of new informa-tion. In our case this information was produced with the Industry Foresight method. In terms of the EUNITE levels of adaptivity the real options model is of Level I.

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