In volatile times, why not try real options?

In volatile times, why not try real options?
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First Published: Thu, Dec 18 2008. 10 29 PM IST

Updated: Thu, Dec 18 2008. 10 29 PM IST
Avinash Dixit of Princeton is an expert in trade theory and his work has inspired much of the research for which Paul Krugman won this year’s Nobel for economics. Dixit is better known among finance professionals for his work on investment under uncertain conditions. This is a less known part of his work but no less important.
In this year where prices of capital, currencies and commodities have fluctuated wildly, the real options approach to decision-making, of which Dixit is a leading proponent, becomes especially relevant. One hopes that as finance managers realize just how critical an addition the real application of options theory can be, he will be considered for the Nobel for his work in this field.
A real option is the right and not an obligation to acquire the gross present value of a project by making an investment—not now but later—and yet before the opportunity becomes irreversible. The old NPV rule states that one should undertake a project only when its present value exceeds its cost. (NPV, or net present value, is a measure used in capital budgeting to assess the profitability of a proposed investment or project.)
Subjective at the best of times, this approach becomes less reliable when the value of basic input elements such as currency and commodity prices vary violently. Moreover, with the gloom that currently envelops markets, the underlying assumptions in many projects may be so pessimistic as to result in showing unduly negative NPVs. Often though, decisions which relegate projects to the dustbins fail to examine whether a small investment being made now gives the company the right to make a larger one later. Similarly, today’s project may be the latch key for future expansion.
Right to flexibility
This right to flexibility—to take a decision at a later date, with more certainty about payback —is especially valuable in times of volatility. The plain vanilla discounted cash flow approaches to valuation ignores the element of managerial flexibility and the possibility that managers can react to new information. That is why option-pricing is so relevant today bridging the gap between valuation and reality.
Real options have a substantive appeal as they add managerial flexibility to the decision-making process. While the value of real options increases tremendously during volatile times, it is also a strong tool whenever we feel we have the flexibility to refocus our strategy, based on new information.
The math that boards are shown usually answers whether the proposal at hand makes economic sense based on today’s information. Boards are rarely shown the implications of delayed investment, inaction and the relative costs of lost opportunity.
We would recommend the use of real option theory as a dialectic at the board, to encourage raising these questions so that investment decisions are made after attempting to quantify, howsoever inaccurately the implications of these choices.
When faced with investment decisions, boards need to ask if their managers can identify the options, and if so, whether they have the ability and resources to exercise these options as new information comes in. In particular, both negative and zero NPV projects need to be examined closely before rejection, to examine if they would be accepted if their optionality were factored into the value.
Despite the natural drawbacks of trying to apply the classical option theory to untraded assets (which is what investments are), there is still enough firepower in the underlying mathematics to provide some value of these options.
Look for options
However, one needs to look out for an option to find one. When companies choose to acquire an oil field licence, which they will not develop right away, they are exercising such an option. Similarly, a small investment in a start-up company can be an option to making a much larger one as it keeps open the right to participate in the upsides of new technologies or markets, while insulating the company from the downside.
When Indian companies enter new markets, they need to assess whether this choice entails an irreversible cost, and if such a decision can be taken later with greater information. The choice to lease space with the right to expand in that location later, or the right to participate in the sequel to a media production, and the presence of asymmetric put-call clauses in joint ventures are examples of options that have value and are often missed.
In all these decisions, businesses may make materially different financial choices by not explicitly evaluating the value of the option. In a similar vein, managements need to enquire whether the investment can be held off, what benefits would accrue by doing so, and what would be lost by waiting and watching.
It is not as though managers are unaware of the value of options as an approach. Managers use real options every day, implicitly, while making their decisions. During Tata Tea Ltd’s acquisition of Tetley in 2000, a part of the value of the transaction was the option value of acquiring a well-known brand which could be extended to new markets.
Rule of thumb hopes that the current volatility across markets will make the use of these techniques explicit and more frequent.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed in this column are personal. Write to him at ruleofthumb@livemint.com
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First Published: Thu, Dec 18 2008. 10 29 PM IST