Real Option Valuation is the tool to help to justify risky investments and provide guidance in the course of project development. By quantifying the uncertainty in the market, managers can judge more accurately the value of a project. In doing, a company can be more profitable and increase in share holder value. In addition the option map as proposed is a map charted out in the planning stage managers that can help adjust and to adapt strategies to the dynamics of market in a faster speed. Adaptability is the success factor for a project in the competitive business environment today.
In the case, the static NPV total product line is $58.06M and the Real Option Valu-ation line is $107.68M. Although both results would show that the investment is a go, the real option valuation is much more valuable. Thus, ROV total product line result is greater than static NPV product line. This however all depends – on the market.
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Through visual maps like the option space and decision tree, managers can adapt by in-clude additional options or sub competitive game to the changing situation both of which can be quantified.
NPV drivers are still very important because it is the basis of the modeling and as-sumption. This is especially true for the making of the forecast. Different sources with different motives will see the forecast differently. Forecaster thus have to take them into account and present their own believe when making the forecast. The process to make the forecast is as valuable as the result because only in making the forecast will a person understand the market. This understanding is vital to the determining of market uncer-tainty driver: upward and downward trend.
Competitive strategy through game theory is a complementary and useful tool to determine competition outcomes. This way it accounts for the competition uncertainty and managers can make adjustment to their plan. Through the profiling of rivals and their product strategy, managers can also gain insightful understanding of their own strategy. This is vital because all products eventually end up on the shop floor compet-ing for customer interest. As important as all the financial data and market forecast in-formation, it all comes down to the product design and the customer whom the design is intended for.
Real Option Valuation is the next evolution to NPV. Business world today need a
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tool to figure out how to manage with uncertainty. It may even help to improve the or-ganizational culture and align stake holder’s interest to the project.
Real Option Valuation Implementation in the company
In implementing a strategy, managers should seek out matching control process and organizational structure. The strategy sets the plan with the control process execut-ing the plan and finally with the organization structure to support the efficiency of pro-cess to meet the plan at the intended time. This creates congruence and strategic fit to the intended plan. This is especially important for ROV method which requires inputs from the status of the market.
The process of control in Real Option Valuation is a matter of gathering the right information and identifying the matching scenario to execute the option. All stakehold-ers interfacing with different part of the value chain can contribute dynamics of real time decision from the management. The controlling process is much easier to imple-ment and information travels faster now with the availability of information technology system. With understanding and agreement to the ROV key drivers, stake holders can feed back information which will improve the overall adaptability of the company to the changing environment.
The organization structures to support ROV method are structures that work well with uncertain future. Structure like strategic business unit, matrix project structure or
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market or customer group all emphasizes on adaptability to uncertain environment. This is evident in many of the technology companies. Furthermore such structure emphasizes on autonomy to improve the reaction speed to the environment through decentralized and flatter organization.
One of the biggest worry for an employee in a technology company is to be as-signed to an uncertain project that may perform poorly in financial result. Often the em-ployee’s performance is linked to the financial performance of the project. A project maybe strategically important but it is of little financial value. In such a case, project members are not compensated for its strategic value. The feeling of resentment and abandonment may creep up over the moral of the team members.
Through Real Option Valuation, company can re-align interest and performance evaluation with employee. Typically, uncertainty in the project is undesirable to the project stakeholders since they are compensated by the financial success of static NPV calculation. Uncertainty to ROV on the other hand is valuable which in turn is also val-uable to the stake holder because they can be compensated for risky projects.
In this way, the stakeholder’s compensation does not depend entirely on the market performance of the project which is exogenous to the firm. Company and project mem-bers can reach an agreement on work performance evaluation that is based on executing the option and the timing to do so. Stake holder’s interest would then turn to reaction of
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the situation and the speed to do so. More involvement from different functional group can mean more adaptability to project’s dynamics in the market which would probably improve the financial success rate of the project.
Obstacles in Applying Real Option Valuation and solutions
Real Option Valuation method would require more time and man power to plan and control it despite being the simpler math and concept proposed in this paper. Ini-tially it would prove to be difficult due to the learning curve of understanding the con-cept of option valuation. The understanding of basic financial theory like NPV is low for a typical company. The adaption for ROV is going to prove even tougher. Further-more, while management can be sole user for NPV to make decision, ROV involves all stake holders’ participation. ROV method compare to NPV has no definite answer. For NPV the definite answer to invest or not to invest rest on whether the outcome is posi-tive or negaposi-tive. ROV on the other hands depends on the market dynamic making eve-rything dependent on further subjective interpretation.
As with all financial tools, Real Option Valuation is a tool to help guide manager’s intuition. Conversely, it could be used to justify and cement the manager’s faulty posi-tion. This is could be the undoing of ROV method because ROV accounts for different possibility which managers could use to cement its faulty intuition. It could drive the course of the project to disaster.
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In typical financial option, the exercise timing is clear. This is not the case for real option exercising timing. For real option, the exercising time is a time frame at which a company can adjust its strategy to the environment. However no one can say exactly the size of the time frame and the effect for exercising early or late in the time frame.
For accuracy the sampling timing for the decision tree should be finer (with more variations) but too much variation makes it conceptually difficult to understand. Con-verse may also prove to be a problem where the decision tree variation level is too broad to be anything accurate. In general, how much decision tree variation level is enough is hard to say and really depend on the project, the company and on the situation. There is also the problem with uncertainty over the time scope of the project. If the project is much longer like public construction of a dam which could take decades to complete, the variation level can be too much and uncertain to assist in decision making because the outcome would be too inaccurate.
This all ends up with the upward and downward trend. To estimate the upward and downward is one of the biggest obstacles ROV practitioners have to face.
Follow up work
One of the toughest tasks for Real Option Valuation analysis and valuation is the estimation of upward and downward trend. What number to use and how to justify the factors is not clear. The upward and downward trend encompasses too many factors and
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each one bears no direct relationship to the construct of the upward and downward trend.
In addition, to back up the upward would need some sort of statistical referencing which is yet to be researched upon.
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Appendix
Competitor information
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Competitive strategy frame work
Competitive strategies depending on type of investment (proprietary vs shared) and na-ture of competitive reaction (contrarian vs reciprocating) (Trigeorgis & Smit, 2004, p.
232)
Company B simulated rate of return
WACC = 9.9%*65% + 4.1% * 35% = 7.9%
• Re= 9.9% (Park, 2012)
• E/V= Weighted equity = 65% (Park, 2012)
• D/V= Weighted debt = 35% (Park, 2012)
• Rd = 4.1% ( tax adjusted ) (Park, 2012)
• Rf = 3.25% (trading economics)