Reality Check for Real Options

Applying Black-Scholes analysis to capital spending projects has one big flaw.

It’s time to get real about real options. To be sure, this much- vaunted alternative to the conventional method of evaluating capital- spending decisions using net present value (NPV) is catching on with more and more senior finance executives. To one degree or another, CFOs and strategic planners at companies ranging from Anadarko and Enron to Times Mirror and Hewlett-Packard are self-confessed admirers of this theory, which posits that the evaluation of financial options can be applied to other investment decisions.

There’s no question that many, if not all, of the potential investment decisions companies face include scenarios analogous to financial options. “We have portfolios [of real options] whether we recognize it or not,” says Corey Billington, vice president of supply- chain services at HP. The issue, as Billington sees it, is how they’re managed. “We need to use these capabilities better than our competitors,” he says.

But real options work only if a company is truly prepared to cancel a project if the numbers look bad after the initial investment. The flaw in the theory is not its complexity, as some have said, but the fact that it ignores the psychological and political realities of capital investments.

Granted, the technique for valuing real options–based on the Black- Scholes method for modeling option prices–is more formidable than that used in NPV calculations, at least at first glance. With the latter approach to capital budget decisions, an appropriate discount rate is applied to a project’s anticipated cash flows. If the resulting present value of those cash flows exceeds the cost of capital and the NPV of alternative investments, the company proceeds with the project. With real options, also called strategic options, a decision tree is plotted showing a series of different scenarios that could develop at various points throughout the life of the project. Then probabilities and discount rates are attached to each scenario and the cash flow is discounted back to the present. If the outcome is positive, the company makes at least a partial investment.

The most important difference between real options and traditional NPV is that while NPV analysis is basically an all-or-nothing approach, real options analysis lets a company make an initial investment and then proceed–or not–as the project develops. This “go/no go” flexibility enhances any project’s potential appeal.

The trouble is, the flexibility created by a Black-Scholes analysis must be supported by corporate discipline for the analysis to hold any water. Traditional financial options, after all, are contracts with a specified expiration date, and their value tracks that of an underlying security. This explains why real options analysis can so readily be applied to projects in the energy business, where the use of futures contracts and exploration leases with definite terms is commonplace.

Elsewhere, however, capital investment decisions often do not involve contracts or have a security underlying them, so there’s nothing to trigger expiration of the option or help assign a specific value to it. Sure, you can estimate precise outcomes for a project’s scenarios over specific intervals, and thereby manipulate them to resemble financial options. You can also securitize the projected cash flows, as noted finance theorist Robert Merton has recommended. However, securitization may not always be effective, especially in pharmaceuticals and other industries in which there is considerable regulatory and other exogenous risk. As Nalin Kulatilaka, a finance professor at Boston University, and Martha Amram, a Palo Alto, California, consultant, point out in a recent article in the Journal of Applied Corporate Finance, “When the value and exercise of investment options cannot be linked to risks priced in the financial markets, the value of strategic options is better captured by other frameworks.”


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