CHAPTER 2 Taking an Idea into Practice. Real option analysis values and rewards managerial insight and the resulting flexibility. Managers may delay an investment until further information is available to provide better insights into market conditions. They may change the scale of an ongoing project by either downsizing or expanding it. | Taking an Idea into Practice REAL OPTION CONCEPTS AND APPLICATIONS Real option analysis values and rewards managerial insight and the resulting flexibility. Managers may delay an investment until further information is available to provide better insights into market conditions. They may change the scale of an ongoing project by either downsizing or expanding it. They may decide to abandon a project altogether. They may decide to exchange input resources that is switch from one energy form to another or from one product output to another. They may also decide to structure an investment into a major new project in incremental steps with an option to grow at each step while at the same time obtaining valuable market and product information. Finally they may want to stage a very risky investment into a new technology or into a new prototype incorporating multiple go and no-go decision points based on conditional probabilities of achieving certain milestones along the way. The initial real option work focused on the value created by abandoning a project and liquidating the A project that can be abandoned so the reasoning goes is in essence an American put option on a dividendpaying stock It gives management the right but entails no obligation to sell the asset at a salvage price the exercise price at any time but it will forego the cash flows generated by the asset equivalent to the dividend on a stock as shown in Figure . This managerial flexibility has value and the value can be determined using option pricing theory. Management will make use of the abandonment option once market conditions have deteriorated and the potential value created by the asset such as a production plant or an airplane fleet over its remaining lifetime is lower than the value created by selling it. The value of the 33 34 REAL OPTIONS IN PRACTICE FIGURE The abandonment option put is the salvage price minus the costs incurred to exercise the option such as transaction costs .
