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A real option is regarded as an economically valuable right that helps to make or to abandon certain choices available to the company’s managers, generally concerning investment opportunities or business operations and projects.
The term “real” is the typical reference to projects that involve tangible assets, such as inventory, buildings, Land, or machinery. Also, real options involve real Underlying assets and cannot be exchanged as securities.
Real options, basically, are choices that the management of a company gives itself to change, curtail or expand projects on the Basis of changing Market conditions, technologies, and the economic situation.
Computing real options impact the valuation of possible investments. However, valuations that are commonly used somehow Fail to Factor in the possible advantages offered by real options. Also, the managers of a company can estimate the opportunity cost by using Real Options Value Analysis (ROV).
This helps them decide whether to continue a project or abandon it. It is essential to note that real options don’t denote to a derivative Financial Instrument, like as put and Call options contracts that provide the holder with a right to purchase or sell an Underlying Asset.
Rather, real options are such opportunities that a company may or may not take the benefits of. For instance, Investing in the latest Manufacturing equipment might provide a firm with real options for introducing newer goods, combining operations or making adjustments according to the changes in the market conditions.
While figuring out whether to invest in the latest equipment, the firm must consider the real option value that the equipment offers. Some of the other real options examples include potential mergers and acquisitions or joint ventures.
McDonald’s Corporation owns restaurants in 100+ countries. Suppose the executives of the company are considering to open new restaurants in India. This expansion will come under the Real Option to Expand category.
The Capital outlay or investment will have to be calculated, including the cost of equipment, staff, land, physical buildings, and more. However, apart from this, the executives of McDonald will have to decide whether the earned revenue from these new restaurants will be satisfactory to fight against any possible political and country risks, which would be quite difficult to value.
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The similar situation may also generate a Real Option to Wait or postpone opening any new restaurants until a certain political situation is resolved.