Real-Options Analysis: The Real Story
Business's standard decision-making tool of net present value (NPV) which calculates the merits and worth of a single project, predicting its investment return by subtracting investment and adjusting for risk, is no longer the gospel for some businesses. Real-options analysis rewards flexibility wherein businesses keep their options open to a number of possibilities, a concept that in the past might have been deemed ill-considered, and prohibitively expensive.

The concept was first developed in the 1970’s when Myron Scholes, Robert Merton, and Fischer Black won the Nobel Prize for their breakthrough in how to correctly price financial options. These scholars realized volatility was a pivotal factor and recognized the value of placing options to buy stock shares at higher prices was greater than the risk if prices dropped, where the options could then be allowed to expire. The Black-Scholes formula transformed financial-options trading in the Chicago pits in such sectors as gas, oil, gold, and copper, where the use of this application remains popular. It also helped create a global derivatives business valued in the trillions of dollars.

But now many manufacturing businesses face the rapid changes and uncertainties of the New Economy with this proven analysis too. For them it has become the age of scenario planning where rapid change has exposed the weaknesses of less flexible valuation tools. Now industries like pharmaceuticals, biotechnology, software, computer chips, and similar fields are using it for planning production. Hewlett-Packard, for example, has opted for shifting location of custom fitting their ink-jet printers from factory to warehouse, and to customize from there only in response to order demands. A more expensive process in one perspective, but cheaper in the long-run since their orders now match demand, rather than storing inventories of over-produced custom units, only to face possible short supplies of others in their inventories. Some utilities companies have built power plants whose running cost is too expensive to use in the present. Their bet is prices will rise in the future, where their operation will bring profit. Some airlines carriers use the theory to calculate the value of the order options it gives to aircraft builders versus the cost to change or cancel orders at the last minute.

Real-options analysis requires sophisticated calculations, but with today’s ever-changing economic scenarios it has proven itself with better answers than the older methods most companies use today to make major investment decisions. While it has its detractors, the general view is that many more businesses will be looking for future MBA candidates to work for their companies who have solid backgrounds in real-options analysis.