Real Options (Strategic Options) in Financial Modeling

The traditional, financial results led approach to assessing the viability of a project or business in a financial modeling exercise continues to work very well today, however, a more strategic approach to decision making has also emerged to complement the traditional process.

Real options (or strategic options) are opportunities embedded in projects or investments that are likely to exist and have a material economic impact on cash flow and risk. The recognition of real options embedded in a project will result in the project’s strategic net present value (NPV) to differ from its traditional NPV, as follows:

Strategic NPV = Traditional NPV + Value of real options

We highlight a number of the most common categories of real options which can occur in when performing financial modeling on a project or investment.

Abandonment Option

The option to terminate or abandon a project before the end of its planned lifespan. This option allows executives or project owners to minimize or avoid monetary losses on projects that turn financially unsuccessful. A good financial modeler who explicitly recognizing the abandonment option when evaluating a project often increases the NPV.

Flexibility Option

The option to incorporate a greater degree of fluctuation / flexibility into a company’s operations, especially manufacturing & production. It generally includes the opportunity to design the manufacturing & production process to accept multiple inputs, use flexible manufacturing techniques / technologies to create a range of outputs by reconfiguring the same set of plant and equipment, and purchase and retain excess capacity in capital intensive industries subject to wide fluctuations in output demand and long lead times in building new capacity from the ground up. A financial modeling and analysis exercise that recognizes this option embedded in a capital expenditure should be able to increase the NPV of a project.

Growth Option

The option to develop follow on businesses or projects, expand in new or existing markets, retool or increase plants, etc, that would not be possible without the on going existence of the project that is being evaluated for implementation. If a project being considered has the potential to open new avenues for growth if successful, then recognition of the cash flows from such opportunities should be included in the financial model of the initial decision making process. Growth opportunities embedded in a project often increases the project’s NPV.

Timing Option

The option to determine when various actions related to a project are implemented. This option recognizes the company’s opportunity to postpone or delay acceptance of a project for one or more time periods, or to either accelerate or slow down the process of implementing a project in response to new information, or to discontinue a project temporarily in response to changes in the competitive landscape or general market conditions. As in the case of the other type of real options, the explicit recognition of timing opportunities in a financial model can improve the NPV of a project that fails to recognize this option in an investment decision.

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