Business finance : theory and practice

Real options
5.13 Real options
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Before we complete this consideration of the practical aspects of investment decision
making, we are going to take a quick look at an approach to investment decisions that
is gaining influence in the real world. Many business decisions can be seen to involve
options and should, therefore, be assessed in that light.
An option is normally defined as the right, but not the obligation, to do something.
In Chapter 1 we took a brief look at currency options. This is an example of a financial
option. What we are talking about here is known as a real option. Probably the easiest
way to explain real options is through a simple example.
Example 5.9
Wessex Mining owns a site in Dorset on which there is an oil well. The business does not
pump oil any longer because the price of oil is such that it is not economic to do so.
Furthermore, projections for oil prices are such that it may never be worthwhile to exploit the
well. Recently, a property developer has offered £500,000 for the site, which it has plans to
develop for domestic housing.
What should Wessex Mining do?
Solution
On the face of it, the well has no economic value, so accepting the offer would make the
shareholders more wealthy by £500,000. On the other hand, Wessex Mining owns an option.
It has the right (because it owns the well) to pump oil whenever it wants, but it has no
obligation to do so. Although projections for the future price of oil may suggest that it is
unlikely that the business would ever choose to produce oil, oil prices can be volatile and
could rise to a price at which production would become economic. This option, therefore,
has a value, and this must be set against the £500,000. Retaining the site does not oblige
the business to produce oil, but it enables it to keep the right to do so. Unfortunately, putting
a value on this option is very difficult, but such a difficulty is not unique to this decision. All
decisions involve trying to value future outcomes.
In this case, as in many in real life, it may be reasonable to turn down the offer from the
property developer and to wait and see what happens to the price of oil. It seems likely, given
the demand for housing in the UK, that the site could be sold for development at virtually any
time in the future. Obviously there is an opportunity cost here. Having the £500,000 would
enable the business to gain income from it, so delaying would have a cost. It would all be a
matter of commercial judgement.
This was a very simple example, and you need not even have heard the word
‘option’ to recognise that the well has a value because the price of oil might rise. There
are, however, situations where the existence of a real option is less obvious but no less
important to the decision.
Graham and Harvey (2001) found that 27 per cent of the US businesses surveyed by
them incorporated a consideration of real options in their investment decisions
‘always or almost always’. Alkaraan and Northcott (2006), in their survey of large UK
manufacturing businesses, found that only about 20 per cent of those businesses
regarded consideration of real options ‘important’. It seems to appear that, for many
businesses, real options are seen as being too theoretical and/or difficult to assess.
See the further reading at the end of this chapter for references to examples of real
options.
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