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Past Issue • Oct-Dec 2013

The Financial Value of Real Options

CAF Academic Fellow Eduardo Schwartz, California Chair in Real Estate and Land Economics, UCLA Anderson School of Management, was at ISB recently for the annual summer research conference. Just prior to his keynote on “The Real Options Approach to Valuation: Challenges and Opportunities,” he spoke with Professor Ramabhadran Thirumalai on real options, and their pricing.

Ramabhadran Thirumalai: You have worked extensively on Real Options. I know that you are one of the fi rst people to come up with the concept of Real Option pricing. Can Real Options introduce some kind of fl exibility in projects from a capital budgeting perspective? And valuing them is very critical because if Real Options are ignored then you mostly underestimate the net present value of the project. So, how does one go about identifying a Real Option? As a manager, how does one think about Real Options?
Eduardo Schwartz: There are two necessary conditions for Real Options. First, you have to have uncertainty about the future and second, you have to have flexibility. You must be able to change your mind as the world unfolds, as the world changes. Uncertainty, along with flexibility essentially, forms a Real Option. In other words, you have the possibility, for example, of abandoning a project if things don’t turn out well, that is flexibility. In traditional valuation methods we discount just one expected cash flow, the mean of the distribution. When we value Real Options we take the whole distribution of cash flows and we don’t have to produce, for example, if the cash flows are very low. We have the possibility of starting production or abandoning the project and so forth. Similarly, if the cash flows are very good we have the possibility of expanding the project. So flexibility and uncertainty are the basic elements for a Real Option problem.

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