Real Options in Capital

Budgeting
By: Dr. Sachita Yadav
 ▪ In capital budgeting, one may use any among the various
methods: NPV or IRR vs PBP vs PI. It is to decide about the
feasibility and commercial viability of a project under
consideration. Such methods, however, do not take into account
the value of any operating (real) options that may come with
the project.
Types of Real
Options in Capital ▪ Also, these traditional methods do not consider any flexibility
Budgeting – All that a company may add to the project. This is where real
options come in.
You Need to
Know ▪ They give businesses more options to evaluate the effectiveness
of the project. There are different types of Real Options in
the Capital Budgeting process.
 ▪ To take care of these practical aspects and situations, Capital
Budgeting offers various Real Options that businesses can use.

▪ Example
▪ One simple example of the real options is: where a business has
an option to end a project before completion. Provided it is of
Real Options the firm belief that the earnings of the project will not be as per
the expectations. This would help the business to cut further
losses as well as minimize the overall losses.
 ▪ The real options in capital budgeting work on the same fundamentals as the financial options. So, it is
important that you know what options are before understanding the real options in capital budgeting. In
simple words, options represent a right, but not an obligation. And the same concept applies to the
real options as well.

▪ Another name for real options is strategic options.

▪ Value Add

Fundamental ▪ Basically, these options are the opportunities that are part of the investment projects. And offer
additional value to the usual capital budgeting decisions.

Principle ▪ Also, the real options enable businesses to change their cash flows, as well as risk profile to make the
project more acceptable and profitable.

▪ Moreover, the presence of these options gives businesses more chances or opportunities to make the
project successful. Or, we can say these options help in preventing the wastage of resources (if the
project fails).

▪ Additionally, these options could help make the project even better and successful than what was
initially planned.

▪ Now that we know what real options are, let us look at the types of real options in capital budgeting.
 ▪ There are five main types of real options in capital
budgeting. Following are the types of real options in Capital
Budgeting:

Types of real ▪ Option to Expand

Options in ▪ Option to Abandon
Capital ▪ Option to Wait

Budgeting ▪ Option to Contract

▪ Option to Redeploy
 Such an option allows businesses to invest more in the future to further expand
their operations. Or, we can say that it allows businesses to put in more money in
the project to enter new geographies. Another name of this option is Growth
Option.
Usually, in this option, the initial project may not be worth investing in as it would
have a small or negative NPV. But, the option to expand further makes this
project somewhat attractive. This is because additional investment gives the
project an opportunity to improve NPV in the future.
If there is an option to expand, the project is worth investing only and only when
the project earns more than the additional investment needed to complete the
expansion.

Option to
Expand
 As the word implies, this option allows the investor to cease or abandon the project
to realize its salvage value. The option gives the investor the right to abandon the
project even before the completion of the project life. Such an option is very useful
as it helps to minimize the losses if the project does not go as per the expectations.
Moreover, this option gives the holder the right to sell the remaining project or cash
flows at the salvage or scrap value. Such an option works like American Put Options.
Generally, the holder sells or abandons the project if the PV of the remaining cash
flows is less than the liquidation value.
Such a type of option is very crucial for capital-intensive projects, like airlines,
nuclear plants, and more.

Option to
Abandon
 ▪ Such an option allows businesses to defer a decision for a
future date. Or, pick up the project when the conditions get
favorable. For instance, a manufacturing firm may delay its
decision to buy a new plant by later this year or the next year.
Another name for such an option is the Timing
Option or Option to Delay.

▪ Generally, a company rejects a project if its NPV or IRR is less

Wait Option than the cost of capital. However, it is possible that a project
that is less valuable today gets more valuable later. This is
where the option to wait comes in handy as it does not scrap the
project, rather keeps it on the back burner till the conditions
improve or turn favorable.
 ▪ This option enables a business to close or shut a project at any time
in the future if the external factors are not favorable. For instance, a
foreign company may decide to end its business in a country if it is
facing political instability.

Option to
Contract
 ▪ As the word suggests, this option allows a business to redeploy
its resources to another project if the original project is not
viable or remains no more viable. Or where another lucrative
opportunity has come up. We can also call this option the
Flexibility Option. It is only logical for a business to use this
option if the PV from the cash flows of a new project is more
than the cost that the business would incur to redeploy its
resources to a new project. Such an option is extremely crucial
for agricultural and utility projects.

Option to ▪ Real options in capital budgeting could prove extremely crucial

for the successful completion or termination of a project at the
Redeploy right juncture. Moreover, it could save businesses from
incurring heavy losses, as well as make more profits.
Businesses can choose from the above types of real options in
capital budgeting depending on the requirements of the project,
as well as their financial goals
 ▪ https://efinancemanagement.com/investment-decisions/types-
of-real-

Reference options#:~:text=%20Real%20Options%20%201%20Example.
%20One%20simple,the%20investment%20projects.%20And%
20offer%20additional...%20More%20