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Finance – What are the types of Real Options?
Real Options
Real options are not an obligation but a right to make business decisions. The idea of a real option is critical to the success of a business because the ability to select the right business opportunity has a significant impact on the profitability and growth of a company.
A real option permits the management team to evaluate and analyze business opportunities and select the right one that will provide the maximum profitability and growth.
As the concept of real options is related to the concept of financial options; the idea of fundamental knowledge of financial options is important in order to understand real options.
Types of Real Options
Real options are classified into numerous groups depending on their nature. The most common types of real options are −
- Option to expand,
- Option to wait,
- Option to abandon,
- Option to switch, and
- Option to contract.
Option to Expand
It is the type of option that helps the businesses to make an investment or undertake a new project in the future to make an expansion of the existing business operations. For example, a restaurant chain considering opening new restaurants is an option to expand.
Option to Wait
It is the option in which the business decision is deferred to the future. For example, a restaurant chain seeking to open a new restaurant in the future is an option to wait.
Option to Abandon
It is the option to exit from a project or cease an asset to realize its salvage value is an option to abandon. For example, a manufacturer opting to sell old equipment is an option to abandon.
Option to Contract
It is the option to close a project in the future if conditions are not favorable is an option to contract. For example, a multinational corporation stopping its operations in branches in a country with an unstable political situation is an example of an option to contract.
Option to Switch
It is the option to close operating on a project at some point in the future for unfavorable and resume it when the conditions become favorable. For instance, if an oil company shuts down the operation of one of its plants when the prices of oil are low and resumes operation when prices are high, it is an example of an option to switch.
Pricing of Real Options
The NPV method is the best approach to calculate real options pricing.
For instance, if we want to calculate the price of an option to expand the business operation, forecasting the future cash flows of the project and discounting them to the present value at the opportunity cost can be used.
We will have to use the option if the calculated NPV is positive and reject it if the NPV is negative.
However, in practice, it is hard to have the NPV approach performed correctly.
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