Question

Briefly explain what real options are and what makes these options valuable.

Can a firm with no ongoing projects and investment opportunities that have only negative NPVs still be an attractive investment? Why?

Why it might not be appropriate to simply pick the highest NPV project when comparing mutually exclusive investments?

Give an example of a real option(s) in capital budgeting process for any "new era" firm (Amazon, Google, Facebook etc.)? Be brief and specific.

Answer 1

1. Real options refer to the choices available to the management for business investment opportunities. It is termed “real”  as it involves projects concerning a tangible asset.
2. A firm with no projects, and investment opportunities and presently having negative NPVs, can still be worth a positive amount if the firm has potential investment opportunities, and thus potential growth prospects.
3. NPV has realistic reinvestment assumptions. It takes into account the cost of capital and provides a dollar value estimate of value-added. NPV analysis also allows for differential risk levels through the adjustment of the discount rate. However, NPV is hugely dependent on project magnitude. If an investor randomly selects a high NPV project by ignoring the relatively smaller NPV projects then it could lose out in the same investment translating into higher aggregate NPV.
4. If Amazon decides to expand its robotics for its warehouses, factories and other places and cut down on manpower, they will have to calculate the investment outlay required which will include R&D expenses, the cost of manufacturing or outsourcing the manufacturing of the robotics. Thus the potential expansion plan is coming under the purview of real options. Amazon will also have to ensure that the returns from the costs exceed the present returns, along with the unforeseen risks that might increase due to the new changes which may also include country and political risks. Therefore, whether Amazon will prefer to take the risks and go ahead with the robotics expansion or decide to postpone it, for the time being, will come under the purview of real options.