This has a cost of $5 million, but increases the value of the project by 30%. And the risk-free rate is 3%.Īt the end of the second year there’s the option to expand. The volatility of these cash flows (their riskiness) is 12%. The initial capital investment is $16 million, and the present value (PV) of the cash flows it’ll generate (without flexibility) is $30 million. Let’s say a company is making an investment for two years and then selling it for its fair price. Read this first example carefully, as we won’t go into as much detail for the next examples because it would become too repetitive. The first real options valuation example is the option to expand. It is essential that you understand what are financial options and what are real options before diving into these examples: #1) Option to Expand Example If it’s not possible (or never optimal) to exercise the real option early (before the maturity date of the project), an European option and an American option will have the same value. Valuing real options starts with defining whether they refer to a now-or-later decision, or a between-now-and-later decision.

Real options vs financial options: Unlike financial options, the underlying asset is a real-world capital project or tangible asset, as opposed to a financial asset.A project where a company is contractually obligated to follow strict rules doesn’t benefit from real options valuation. Real options analysis is most appropriate when there’s a high level of uncertainty surrounding the investment’s expected future cash flows, and managers can change the course of the project throughout its life.Traditional discounted cash flow models don’t do this, which can lead to misleading negative net present value valuations. Advantages of real options: Real options take into account the value of managerial leeway.Real options theory attempts to attribute a dollar value to that flexibility. Firms usually have the executive flexibility to make decisions that increase profits and cut losses. Real options definition: A real option is the right (but not the obligation) to adjust operations in the future in order to adapt to changing market conditions.Let’s start with a quick recap of what you need to know about the real options approach and the expanded NPV: Is a stock option a real option? What Are Real Options

Real options valuation