Question

Projects are also often embedded with different options that can help making decisions under uncertainty. There are techniques used to evaluate these embedded options which are called real options. The models used to value these options are based on the type of the real option available for the project. Real options the value of capital investment projects. Which type of real option allows a firm to postpone a project until it can gather more information or market conditions change? O An input flexibility option O An investment timing option O A shutdown option O An output flexibility option Real option analysis adds value to a project when it is used for which of the following? Check all that apply. Modifying the way that decision makers perceive flexibility in capital budgeting activities Expanding the way that managers view risk and uncertainty, seeing them as phenomena to be appreciated and exploited rather than feared and avoided Increasing the riskiness of the capital project and decreasing the project's cash flows Making managers aware of the consequences of their decisions and actions on the creation or destruction of value for a capital project

Answer 1

Real options increase the value of investment projects, as they provide flexibility by making informed decisions with option to accept or reject the project at the earliest possibility and avoid unnecessary costs that are irrevocable, and irreversible.

An investment timing option gives flexibility to wait and postpone the project to understand more about the market and the changing conditions. It helps to time the capital budgeting process using the timing option.

Options that are appropriate about real options:

• Modifying the way that decision makers perceive flexibility in capital budgeting activities
• Expanding the way that managers view risk and uncertainty, seeing them as phenomena to be appreciated and exploited rather than feared and avoided.
• Making managers aware of the consequences of decisions and actions on the creation or destruction of the value for a capital project

Reasons:

Capital budgeting with real options give decision makers:

• change their decision, using flexibility options, when the project cash flows are not as expected at the initial period. It prevents further losses by using abandonment option and thus save costs for the company
• Options help managers to take chances on the new projects. If unexplored, many potential investments that increase the profitability of the company might be lost. Opportunity cost would be high, without the real time options, as the managers have to make decisions within the capital budget and the time frame with certain restrictions. Real-time options make it comparatively easier to evaluate and change accordingly.
• If the project seems not much worth, it can be abandoned at the early stage. That way, even when incorrect decision was taken or due to the possible changes in the project performance, initial decision might have to be changed.