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14.3: The Role of Real Options in Investment Decisions

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    A real option is a decision or choice to invest a little or a lot in a product, a technology, or a project. They are called real options because they are investments in tangible assets, products, processes, and services rather than financial instruments such as stocks. For financial investments, option-pricing techniques are heavily used to take into account the flexibility issue. The most popular is the Black–Scholes option-pricing model where the option value is determined by five input values of the exercise price of an option, the time to exercise date, the current price of the asset, the variance per period of rate of return on asset, and the risk-free rate of interest. If you plug all these values into the Black–Scholes option-pricing model, you would get a positive value (do not forget all options have a positive value). This is the option value. This value would be added to the NPV analysis. So, what is initially a negative NPV would become a positive NPV once the project’s option value is incorporated. This calculation looks very simple. However, investments in technology differ from those in financial assets in terms of priceability and tradability of the underlying asset. Contrary to financial investments, in technology investment situations, the price of an underlying asset is hard to know, and the underlying asset cannot be traded easily.

    The purpose of a real option is to explore the potential of a product or new technology. Car manufacturers are constantly making small investments (from their perspective) in emerging technologies. They purchase real options in fuel technologies, engine technologies, drive-by-wire technologies, steering and braking technologies, advanced construction materials, and design. Sometimes they invest a little money and just search for information and try to understand whether a technology is applicable and cost-effective. Sometimes they invest a lot of money and develop full-blown prototypes using a variety of technologies and showcase the technologies in the so-called concept cars. Sometimes they decide to go whole-hog and develop a fresh line with modern features and technologies. Sometimes they just abandon a product or a technology completely.

    Amazon did not just settle into the production of the Kindle e-book. They explored various technologies such as the screen technologies, the book delivery mechanism, and the file format for storing the books as well as if consumers would be interested in reading e-books.

    The following example illustrates how a real options analysis can be conducted.

    Jin Beans Tonic Elixirs

    Jin Beans Tonic Elixirs produces exotic health drinks containing a combination of vitamins, herbs, fruit extracts, and supplements.The company used in the example is fictitious. Jin Bean is a compendium of numerous examples of actual companies that have decided to go ahead with an investment in the face of negative values for NPV. See Mauboussin (1999); Mun (2005); Trigeorgis (1996), for additional examples that also include financial calculations. The competition is fearless and they compete with a number of highly competitive vitamin water, energy drink, and sports drink and boutique drinks in the water industry. They are known for delivering healthy drinks in unique high-quality safe plastic biodegradable containers. The super high quality of their ingredients, the design of their bottles, as well as the design of their labels set them apart from the competition.

    Most of their bottles are being produced overseas and because they change the design of the bottles every 2 months, the cost of design, development, and delivery is very high. They are exploring the idea of manufacturing the bottles at each of their five bottling centers in the USA. This will require the purchasing of injection blow molding equipment (see Figure 14.3 "Blow Injection Molding Diagram", for an overview of the blow molding process).

    Jin Beans Real Option Decision

    The president of Jin Bean’s assembled a group of financial analysts; the marketing department and the operations department conducted a study to ascertain the cost of switching bottle production in-house. They determined that it would cost the company an additional $1 million per year to purchase the machines, hire staff, and maintain the machines over what they are currently paying to import their bottles. Each machine costs $250,000 and will involve personnel costs and maintenance costs exceeding $100,000. No matter how they put the numbers together, they could not generate a positive NPV. Even though the figures did not look good, the presidents of Jin Bean decided to go ahead and purchase one machine and install it in Florida. The decision of Jin Bean’s president was based on her knowledge of real options analysis. By purchasing and using one machine, they were able to learn and conduct an economic experiment. The company could obtain insight and also acquire the flexibility to expand in the future as the effect of the investment on the bottom-line gets clearer and knowledge about the use of the machine is accumulated.“Permission is granted to copy, distribute and/or modify this document under the terms of the GNU Free Documentation License, Version 1.2 or any later version published by the Free Software Foundation; with no Invariant Sections, no Front-Cover Texts, and no Back-Cover Texts. A copy of the license is included in the section entitled GNU Free Documentation License.” http://commons.wikimedia.org/wiki/File:Blow_molding.png

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