The Real Options Theory

The Real Options Theory

05/14/2012

The Real Options Theory

Introduction

The real options theory has become a vital tool for companies that are thinking of making an investment. The real options theory provides a set of analytic tools that evaluate and deal with the ambiguity that permeates strategic decisions. It requires research to make predictions of financial stability and it also exclusively posits a payoff structure for investments with fixed options by suggesting that real options enable companies to reduce downside risk while accessing upside opportunities. Compared to other theories, the real options theory suggests that the greater the level of flexibility, the higher the potential payoff to the option holder (Tong & Reuer, 2007)

Define

The real options theory sets in motion by comparing the similarities between real options and financial options. Real options give the holder the right, but not the requirement, to buy or sell their asset at a specified price on or before a given date (Westerfield, Jaffe & Jordan, 2009). The concept of real options was developed from an idea that a company manager can view the company's flexible investment chances as a call alternative on real assets. It is a given that companies often face changes, questionability, competition, doubt and budget adjustments. With that in awareness, companies cannot willingly depend on discounted cash flows. Instead they can choose to postpone, increase, agreement, abandon or alter the project while using real options (Westerfield, Jaffe & Jordan, 2009). This theory is the right not an obligation to start certain business enterprises, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. The notion of real options was first established from knowledge that a corporate manager can view the company's discretionary investment...