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Real Options and Game Theory - Annual International Real Options ...

Real Options and Game Theory - Annual International Real Options ...

Real Options and Game Theory - Annual International Real Options

Real Options and Game Theory – preliminary draft, do not quote March 2002Real Options and Game Theory:When should Real Options Valuation be applied?Helen Weeds, Lexecon Ltd, London, UK 1March 2002Preliminary draft – do not quoteJEL Classifications: D81, G31, L20, M20Keywords: Real options, investment policy, game theory, pre-emption1. IntroductionAt a recent conference on real options, a delegate from a telecommunications company raisedthe following query in response to a speaker from a firm of management consultants.Paraphrasing somewhat, he said: “You’ve stressed the importance of ‘holding the option’ anddelaying investment decisions. Last month a consultant from your company advised my firm,a telecoms company, to act decisively, stressing the importance of committing to the marketand seizing the advantage over our rivals. Isn’t all this rather contradictory?” The reply castlittle light on this apparent conflict, amounting to little more than “Well, real options can’t beapplied everywhere.”In recent years there has been considerable interest in real options as a valuation method andinvestment appraisal technique. In addition to a multitude of specialist textbooks (see, amongothers, Trigeorgis (1996), Amram and Kulatilaka (1999) and Copeland and Antikarov(2001)), the real options approach is also now covered in standard texts such as Brealey andMyers (2000). The technique has been applied to a number of areas including valuation of oilleases, patents and real estate.Despite initial enthusiasm, real options valuation has proved difficult to put into practice. Thetechniques are significantly more complex than the established investment appraisal methodsof discounted cashflow (DCF), return on capital employed (ROCE) or payback period. Realoptions valuation requires detailed analysis of all possible future developments, and thedegree of uncertainty surrounding these possibilities, not just the expected outcome.Managers are also required continuously to monitor the development of the businessenvironment, considering whether conditions merit the exercise of a further investmentopportunity, or whether they have deteriorated so far that abandonment of the project is nowadvisable.Even assuming that these practical difficulties can be overcome, a fundamental issue remainsto be resolved. When exactly should real options be applied? Is it always relevant, or arethere situations in which the established DCF-based methods are superior? There are, even1 Contact address: Lexecon Ltd, Orion House, 5 Upper St Martin’s Lane, London WC2H 9EA, UK.Email: helen@lexecon.co.uk. Tel: 020 7240 6740.1

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