Real Options and Strategic Investment
Investment
Real Options and Strategic Investment
Syllabus tag: KASNEB CPA | Advanced Level | CA33 Advanced Financial Management | Topic 4 Real Options and Strategic Investment
Lesson objectives
By the end of this topic, you will be able to:
- Explain why conventional NPV understates certain projects
- Identify the main types of real option
- Value an option to abandon and an option to expand
- Relate real option value to the drivers of option pricing
- State the limitations of the approach
Why this matters
Conventional NPV assumes the project is accepted now and run to the end regardless of what happens. Real management does not behave that way — it expands what works, abandons what does not, and waits when waiting is informative. That flexibility has value, and NPV values it at nil.
Why NPV understates flexibility
Discounted cash flow takes the expected cash flows and discounts them. It implicitly assumes a passive commitment: the decision is taken once and never revisited.
The consequence is a systematic bias. Projects whose value lies mainly in what they make possible — a pilot plant, a research programme, a foothold in a new market — appear unattractive on NPV alone, because the follow-on opportunities are not in the cash flows.
Uncertainty makes an option more valuable, not less. That reverses the usual intuition. In conventional NPV, more risk means a higher discount rate and a lower value. For an option, greater uncertainty means a greater chance the flexibility will be worth exercising — while the downside stays capped.
Types of real option
| Option | The flexibility | Analogous to |
|---|---|---|
| To delay | Wait for information before committing | A call option |
| To expand | Scale up if the project succeeds | A call option |
| To abandon | Exit and recover a residual value | A put option |
| To redeploy | Switch inputs, outputs or markets | A switching option |
| Follow-on | Undertake a further project only available if this one proceeds | A call option |
The option to abandon is a put — the right to sell out at a floor price — while the others are calls. That distinction matters when relating them to option pricing.
Valuing an option to abandon
A project's outcome becomes clear after one year. There is a 60% chance the remaining cash flows are worth KES 40,000,000 and a 40% chance they are worth negative KES 18,000,000. The company can instead sell the assets for KES 12,000,000. Discount rate 12%.
Without the option — the company must continue whatever happens:
(0.60 × 40,000,000) + (0.40 × −18,000,000) = 16,800,000 Discounted: 16,800,000 / 1.12 = KES 15,000,000
With the option — in the bad outcome the company abandons for 12,000,000 rather than continuing for −18,000,000:
(0.60 × 40,000,000) + (0.40 × 12,000,000) = 28,800,000 Discounted: 28,800,000 / 1.12 = KES 25,714,286
Value of the abandonment option = 25,714,286 − 15,000,000 = KES 10,714,286
The whole value comes from not being obliged to continue. Nothing about the good outcome changed.
:::checkpoint The abandonment value rises from 12,000,000 to 20,000,000 because the machinery is more readily resaleable. Compute the new option value and explain in one sentence why resale markets affect investment decisions. :::
Valuing an option to expand
A project costs KES 20,000,000 now. After one year it is worth either 34,000,000 or 8,000,000, each equally likely, discounted at 12%:
Base NPV = −20,000,000 + (0.5 × 34,000,000 + 0.5 × 8,000,000) / 1.12 = −KES 1,250,000
On conventional analysis, reject.
But if the good outcome occurs, the company may invest a further 15,000,000 to obtain cash flows worth 26,000,000:
Value of the expansion option = 0.5 × (26,000,000 − 15,000,000) / 1.12 = KES 4,910,714
Total value = −1,250,000 + 4,910,714 = KES 3,660,714
The project should be accepted. It is a loss-maker on its own and a worthwhile purchase of the right to a larger opportunity.
This is the pattern behind pilot plants, trial markets and research budgets. A company that appraises each on standalone NPV will systematically reject the projects that create its future.
What drives real option value
The same five factors as a financial option:
| Factor | Effect on a call |
|---|---|
| Value of the underlying opportunity | Higher value, higher option |
| Exercise cost | Higher cost, lower option |
| Time to expiry | Longer, higher |
| Volatility | Greater, higher |
| Risk-free rate | Higher, higher |
Volatility and time are the two that surprise people. A more uncertain opportunity is a more valuable option, and a longer window to decide is worth more than a short one — because in both cases the downside is limited to what has already been committed.
Limitations
- Inputs are hard to estimate, particularly the volatility of a non-traded opportunity
- Black-Scholes assumes a tradeable underlying asset, which a factory is not
- The option must be genuinely exercisable — an option to abandon is worthless where contracts, regulation or reputation prevent exit
- It can be used to justify weak projects by attaching speculative option value to them
The last point is the practical danger. A real option analysis should identify the specific decision, the date it must be taken, and the cost of exercising it. An unspecified claim of strategic value is not a real option.
:::checkpoint A director argues that a loss-making project should proceed because of its "strategic option value". Set out the three questions you would ask before accepting that argument. :::