Define the concept of a real option. Discuss some real options a firm can be confronted with when investing in real projects.
A positive APV project is accepted under the supposition that all future operating decisions will be optimal. The management of firm does not know at the inception date of a project what future decisions it will be confronted along with as all information concerning the project has not yet been learned. Accordingly, the firm’s management has alternative paths, or options, that it can take like new information is discovered. The application of options pricing theory to the evaluation of investment options in real projects is termed as real options.
The firm is confronted with several possible real options over the life of a capital asset. For instance, the firm may have a timing option as when to make the investment; it may have a growth option to raise the scale of the investment; it may have a suspension option to temporarily cease production; and, it may comprise an abandonment option to quit the investment early.