Real Option Approach
The real options approach (ROA) to valuation is the process where managers and keys stakeholders in a business or organization are drafted for and presented investment opportunities and ventures(Grenadier, 1995). This is to enable them to evaluate and identify potential ventures to invest in and expand their business operations. It often involves those projects which have tangible assets such as land, buildings, machinery, and other apparatus. Real valuation analysis entails the valuation of those opportunity costs that firms can easily substitute or do not without having a tremendous impact on the performance and operations(Huchzermeier & Loch, 2001). In other words, it is the opportunity cost valuation which arises from the failure to invest in particular projects or the value of the potential project for investment.
Real option refers to the right that a manger or firms has to undertake explicit business ingenuities, such as abandoning, deferring, staging, expanding, or constricting their capital investment venture. For instance, the investment opportunity of developing a firm’s factory, or to sell the factory, is a real call or put option, respectively(Copeland & Howe, 2002). Generally, Real option Valuation has nothing to do with intangible assets owned by any company/firm, for example, the financial instruments, human capital such as skills and knowledge(Fernandes, Cunha, & Ferreira, 2011). Also, options contracts that allow the investors to either sell or purchase underlying assets at future dates at pre-agreed prices are not part of Real option Valuation. With a slight exception, however, some unique intangible assets like mergers and acquisitions, expansion of businesses, investment in new products, investment in new manufacturing facilities, can be considered in real options valuation. Real option approach to assessment is a detailed process and wide-area, but in a nutshell, some of the critical characteristics are covered as discussed hereinbelow.
A real option is any type of investment choices that are made available to managers of firms and business or companies which are directly in a business investments opportunity. That is, the company managers have various responsibilities in the companies. One of the essential tasks that the managers of firms have is to consider investment opportunities(Grenadier, 1995; Miller & Waller, 2003). Through the introduction of new markets into the same existence market by merely differentiating their products to attract new customers, a company can increase its profits. Also, another great option is to venture into a new product and get into a whole new market and expand its operations, which will enable it to grow and earn more profits and be stable. At times, the investment opportunities could include mergers and acquisitions(Fernandes et al., 2011). Therefore, the real options are those investment opportunities that are presented to the managers of companies, and they do not relate to any business idea which has nothing to do with opportunities of investments.
Further, a real option is known as business projects that include tangible assets in comparison to financial instruments. Thus, real options analysis is focused on presenting the opportunity costs of investing in financial instruments to managers of companies. Once managers contemplate in investment in financial instruments such as option contracts or stocks, then it becomes necessary to present to them the real options that they could conduit those investments. That is, the managers will establish the tangible assets that they could acquire with those finances instead of investing in the financial instruments. The real options will provide the managers of companies with the possible mergers and acquisitions that they could spend their funds. This is either by providing them with new products to start making or venture directly into a wholly new product,
Moreover, Real option too includes such decisions such as that of waiting, abandoning, or deferring projects, especially those they feel have no much profit to the firm. So, in real option, managers are critically faced with the decision-making process of expanding their companies and make more profits. Additionally, RO also guides the managers to delay until real opportunities arise as opposed to investing in financial instruments that involve high risks. The real option could as well advise the managers to defer investment in some areas of production until later at the precise dates when the best opportunities come around. Besides, the valuation approach could advise the managers on those opportunities of investments they deem non-profitable to be abandoned, especially those that are intangible assets. Thus, the valuation is critical in providing the managers with the best information and piece of advice on the investment opportunities available that would make them cut an edge in their specific industry of operation.
Lastly, as companies want to make those investment decisions that have higher levels of flexibility accompanied by potential benefits, Real Option is the best tool to use. Companies will make those investment decisions based on the best available opportunities and the right time to take such risks(Huchzermeier & Loch, 2001). These decisions are made after enough data and information about the market, and the possibility of earning from such arrangements are gathered and in-depth analysis done by an expert team in financial instruments and economics. The company will, therefore, be flexible enough to invest in the best available choices as well as get tremendous benefits when making future investment choices. The real options approach ROA is involved in decision making or the making of choices on investment opportunities for the company by the managerial team led by the manager(Copeland & Howe, 2002). Those tangible assets presented to the managers of the companies for investment through real options analysis are to provide the managers with the investment choices. Through the availability of enough data and opportunities for investment choices, managers work on valuation of projects to appraise one and adopt it becomes a more straightforward job and leads to them picking the one that is of best profit to the company.
Strengths of Using the Approach
There are several advantages and strengths of using ROA in making investment decisions as it is more efficient and simpler to construct and adopt and effective. The real options approach is an essential technique that providers the managers of companies with the right value of tangible assets. The physical assets are less risky as compared to financial instruments that some mangers could choose for investment. Therefore, this type of approach is focusing on a single area of investment is a more productive and precise method to use as it also gives managers a little risk in making investment decisions.
Weaknesses
There are various limitations, however, that ROA has in helping the investment decision-making process to managers in a company. The approach is more focused on tangible assets, which could lead to opportunity costs in the investment options neglected by the procedure and neglecting the intangible assets, which may be of much impact on the company’s investments such as personal skills. The financial instruments have proved to be more productive than tangible assets if the investor chooses the right options. However, the real options approach could be discouraging to such types of investments. And thus, the relevance of Real optionsoptions, even as a thought framework, may be limited due to market, organizational,, and/ or technical considerations. When the structure is employed, therefore, the analyst must first ensure that ROV is relevant to the project in question. These considerations are as follows.
Question 2: Mafutee Case Study
Interpretation of the Case Study
In Muftee case study, the manager used the real option approach (ROA) in estimating the net present value of an auction of almost twenty years. Mafutee major concern was to try and understand the bidding price for the auction so that it would not run into a loss in the market. There are several factors considered by Mufteee in the case study such as the lease price, productivity capacity in the number of barrels that the company could produce from the well after its completion, the tax rate, risk, depreciation of the lease, among others. It revealed that the investment had an NPV of $433 million. Therefore, any bid above $433 would result in losses to Mafutee. Muftee’s decision to use Real Option Approach in making its investments decision was fueled more by the advantages it has and the available data they had gathered on their choices.
Suitability of the Approach
Real Option Approach was most suitable tool to use since it provides the value of the investment option that a company intended to acquire and also due to its simplicity and precision. Since Mafutee had already prepared to auction the lease but wanted to know the auction price that it needed to bid. Otherwise, its failure to consider approaches such as real option would have misled Mafutee to bid at an auction price which would sabotage the company and only result in losses. However, the real option valuation considered various factors such as task rate which makes it the most suitable for this case. It also considered the total number of barrels that the well could produce plus the cost of production as well as the prevailing spot price per barrel. The valuation considered the total investment costs which was $1250 million in the estimation of the net present value by deducting the total investment cost from the present value of the lease. In addition, the number of oil extraction to maturity as well as the oil convenience yield further helped in the estimation of the right value of the real option approach. Besides, it valued a tangible asset since the land is a tangible asset that allows an investor to use it based on the agreement until the expiry of the lease. Based on all the above considerations and position that Muftee was in, the only suitable approach to use was Real Option Approach ROA.
Analysis
From the given data and after thorough analysis it was found that the lease would result in revenues worth $5695.70 million over the ten years period of extraction. Though it was also necessary to estimate the present value of the costs which resulted in $4013.06 million over the period. As a result, the present possible right value that the lease would result from the subtraction of the costs from revenues which was found to be $1682.65 million. The investment cost was however, $1250 million and was able to help in getting the actual profit from the investment made by the company. By getting the difference between it and the investment cost, it resulted in net present value (NPV) of $432.65 million. The risk-free rate of 6%, corporate tax rate of 40% and oil convenience yield of 3.5% helped in the estimation of the net present value of the lease. The estimation used the right formula for the real option methodology to get the results for the real value of the investment option. These analysis and data informed major part of the decisions made by Muftee in the case study.
Strengths of the Approach
Muftee was able to acquire a lot of benefits by using the approach in making uits investments decision from being stable to earning a great profit. This approach use which was based on a real option provided Mafutee with the maximum bid it was able to go for in auctioning the oil lease and resulted into higher sales. The methodology was the best for determining the real value of the investment that would enable Mafutee to spend the right amount of finances in the investment. Elsewhere, if they, Mafutee, would have decided to auction the oil lease without taking into account ROA approach, it would have made a bid that exceeding $433 million leading to direct big loss. Moreover, Mafutee was able to see the factors that helped in arriving at the bid price of maximumly $433. Using Real Option Approach was crucial and advanatagious to Muftee and it enabled them to not only dodge loss but also go for a great price that made them earn more and have profit.
Weaknesses
Even though the approach is good and great, there were some few shortcomings it faced and also disadvantages it had during its application by Muftee. ROA considered various factors such as the cost of production, risk-free rate, tax rate, and the prices of oil which took more time to calculate and also complex in obtaining. It also failed to consider some other factors such as calamities and economic crisis such as that resulting from 2008 financial crisis around the world which affected the prices of commodities. Despite of these weakness however, ROA has been the best approach that Muftee could have used in making their investment decision.
References
Copeland, T., & Howe, K. M. (2002). Real options and strategic decisions. Strategic Finance, 83(10), 8.
Fernandes, B., Cunha, J., & Ferreira, P. (2011). The use of real options approach in energy sector investments. Renewable and Sustainable Energy Reviews, 15(9), 4491-4497.
Grenadier, S. R. (1995). Valuing lease contracts a real-options approach. Journal of Financial Economics, 38(3), 297-331.
Huchzermeier, A., & Loch, C. H. (2001). Project management under risk: Using the real options approach to evaluate flexibility in R… D. Management Science, 47(1), 85-101.
Miller, K. D., & Waller, H. G. (2003). Scenarios, real options and integrated risk management. Long range planning, 36(1), 93-107.