real options in real world

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Are "real options" actually used in the real world? Block, Stanley 4,325 words22 September 2007Engineering Economist255ISSN: 0013-791X; Volume 52; Issue 3EnglishCopyright 2007 Gale Group Inc. All rights reserved. The inability of classic NPV analysis to capture the future value of options in a capital budgeting analysisis now well documented by Trigeorgis (1993, 2005), Copeland and Antikarov (2001), and others. In spiteof this, traditional NPV analysis continues to be described as a normative approach. The author surveysFortune 1,000 companies to see if they have picked up on the use of real options to complementtraditional analysis. Out of 279 respondents, 40 were currently using real options (14.3%). While thepercentage is small, the number is higher than in previous studies. The author goes on to describe inwhat manner real options are being used and, of equal importance, why they are resisted by many.Somewhat encouraging is the intent of well over half the nonusers to consider the use of real options inthe future. INTRODUCTION In their highly regarded book published at the turn of this century, Copeland and Antikarov (2001)suggested that real options would dominate the capital budgeting process within the next decade. As these authors and others, such as Trigeorgis (1993) and van Putten and MacMillan (2004), havepointed out, the users of net present value and other discounted cash flow methods may not considerthe flexibility to revise decisions after a project has begun. The flexibility might include terminating theproject, taking a more desirable route once initial results are in, greatly expanding the project if there isunexpected success, and so on. Such elements are particularly likely to be present in natural resourcediscovery, technology-related investments, and new product introductions. But the list does not stop here. Almost every capital budgeting project contains a potential element offlexibility once it is put into place. There is a real option to change the course of action, and this realoption has a monetary value just as a financial option does. While many proponents of real options are critical of NPV analysis, it is not necessarily NPV analysisthat is at fault per se, but rather the improper use of it in many cases. One can use NPV analysis"correctly" if all options (invest, do not invest, delay, etc.) are known at the start of the project such thatthey all can be evaluated. This is why decision trees were developed. The benefit of real optionsanalysis is that it incorporates volatility, whereas decision trees (which rely on NPV analysis) onlycompute expected values. CAPITAL BUDGETING STUDIES AND REAL OPTIONS Capital budgeting techniques used in business have been studied extensively by Mao (1970), Gitmanand Forrester (1977), Schall, Sundem, and Geigsbeck (1978), Scott and Petty (1984), Canada andMiller (1984), Block (2005), and others. The central message throughout is that major industrial firms aremoving toward the normative in various areas of capital budgeting. However, the topic of real options is not covered or scores poorly in terms of utilization. For example, asreported by Teach (2003), in 2000, Bain and Company conducted a survey of 451 senior executivescovering 30 industries regarding their views of management techniques, and only 9% reported usingreal options. Also, Ryan and Ryan's (2002) survey of 208 CFOs found real options trailing the list of 13supplementary capital budgeting techniques with a utilization rate of 11.4%. In contrast, 85.1% of therespondents used sensitivity analysis and 96% used traditional net present value analysis for basiccapital budgeting. In both of these studies, the inclusion of real options was an afterthought with nofollow-up questions or analysis. The current article is specifically dedicated to real options with the intent of finding out who is doing whatand why. It is organized as follows. In the following section, the methodology behind the current study isdescribed; then the presently existing practices using real options are covered, the resistance to realoptions is analyzed, and a summary and conclusion follow, along with the future outlook.


METHODOLOGY UTILIZED IN THE CURRENT STUDY The author used the Fortune 1,000 companies as the initial database for the study. Two hundred andseventy-nine usable responses were returned by the top-ranking financial officer of the firm or hisdesignate. The three-page questionnaire was based on a pilot study of 50 Fortune 1,000 companies toensure clarity of meaning. A follow-up telephone survey of 40 randomly selected non-respondents subsequent to the actualmail-out indicated no statistically significant difference between those who initially answered thequestionnaire and those who elected not to participate. The financial characteristics of the participating firms are presented in Table 1. Of equal importance isthe industry of origin of the survey participants. The industry listings of those firms who participated inthe survey are presented in Table 2. The 12 categories are the most representative of the two-digit SICcodes of the respondents. Not all categories are mutually exclusive, so the emphasis is on the firm'sprimary area of activity. The fraction of responding firms versus non-responding firms, broken down bytwo-digit SIC codes, was generally consistent across all categories. PRESENTLY EXISTING PRACTICES The question of primary interest is what percentage of the respondents use real options as part of theircapital budgeting process. Forty respondents, representing 14.3% of the survey participants, indicatedthe use of real options. Out of the 40 users, 18 indicated major utilization, 13 indicated they used realoptions as a supplemental tool, and 9 reported using real options to shadow the results of morecommonly used methods. In terms of the applications of real options to different types of decisions by the 40 users, the answersare reported in Table 3. While the categories are clearly not mutually exclusive, and many respondents indicated an overlap, it isapparent that the nature of the decisions indicated has a high degree of uncertainty. Clearly, a newproduct introduction has subsequent components in which a decision must be made to either addadditional resources, penetrate different markets, cut back on expenditures, or even abandon theproject. The same type of decisions relate to research and development, mergers and acquisitions, andother categories. INDUSTRY OF USERS In their work, Triantis and Borison (2001) found that there were tendencies among those who employreal options to represent certain industries. Out of the 40 users in this study, 37 came from the following:technology (13), energy (11), utilities (6), health care (4), and manufacturing (3). Interestingly enough,finance had only two users and transportation had one. More will be said about the low participation rateby the financial sector (investment banking, commercial banking, etc.) later in the article. A chi-square independence of classification test indicated that a null hypothesis that there was norelationship between industry classification and use of real options could be rejected at an alpha level of.01. The results are unknown in the appendix. METHODS OF UTILIZATION For the 40 firms that utilize real options, a follow-up question pertained to what technique they used intheir implementation. They were given four major categories as well as another category. The majorchoices were those previously cited by Triantis and Borison (2001) in their research. The responses areshown in Table 4. Needless to say, the approaches are not mutually exclusive and many were used in combination. Theemphasis here is on the primary method of utilization. Also, some respondents used slightly differentnames for one of the four approaches listed here, but the intent was the same and was categorized assuch. While the binomial approach is the most frequently used, it was thought by the respondents to be moresimplistic than the risk-adjusted decision tree approach or Monte Carlo simulation. Although the Black-Scholes option pricing model is the key to valuation for financial options, the samecannot be said for real options. The Black-Scholes model requires knowledge of five variables: the priceof the underlying asset, the price at which the option can be exercised profitably, the amount of timebefore the expiration date, the risk-free rate of interest, and the volatility of the underlying asset. Many ofthese variables are simply unavailable for real option analysis. For example, the time period beforeexpiration can be easily determined for a financial option but is not discernable for a real option, whereflexible decision-making allows for many different potential exercise dates, depending on how theproject is progressing.


To determine if there were industry preferences among the four different methods of utilizing realoptions, a chi-square test was once again run in which the null hypothesis was that there is norelationship to the technique used with real options and industry classification. The null hypothesis couldbe accepted at almost any reasonable level of significance. There is no discernable relationshipbetween technique used and industry classification. The results are shown in part b of the appendix. In their research, van Putten and MacMillan (2004), Trigeorgis (2005), and others have stressed theimportance of treating real options as a component of expanded net present value rather than as astand-alone approach. The NPV is determined and the value of the real option is added. Total value = passive NPV + real option value + other adjustments Thus, it is possible to have a project that has a negative net present value but a positive total projectvalue because of the presence of the real option. By failing to account for the real option value, anincorrect decision may be made. This is particularly likely to happen in projects in which there is a highdegree of risk but also a large amount of flexibility. The classic NPV approach, if not properly used, mayfail to pick up the value of being able to change the plan in the early, middle, or late stages of theproject. The classic NPV is likely to have the greatest value in the early years of the project because ofthe time value of money, whereas the real option component may be more valuable in the later life ofthe project because uncertainty may be at its highest level and flexibility at its most valuable point. Thus, classic, stand-alone NPV, if not properly used, may undervalue potential rewards in the researchfor new drugs in the pharmaceutical industry, the exploration for natural resources in the energyindustry, and so on. Eighty two percent of the respondents employing real options indicated that theyuse the valuation of real options as a component (add-on) to the classic NPV approach rather than as astand-alone item. The classic NPV is retained but modified to reflect how managers think and act in thereal world. Of further interest is the fact that 32% of the respondents indicated that the decision to reject wasreversed after the introduction of real options into the analysis. NONUSERS OF REAL OPTIONS Two hundred and thirty-nine out of the 279 respondents indicated they did not use real options. Whenasked for the reasons why, the answers in Table 5 were provided. The number one reason for not using real options is the lack of top management support. While that cantake on many different meanings, further comments indicated that the top managers of many companiesare hesitant to accept a methodology they cannot follow step by step. Many felt that top managementwas turning decision-making over to mathematicians and decision scientists, and they were being takenout of the loop. While van Putten and MacMillan (2004) emphasized that real option decisions could be simplified to ago, no-go approach to an investment, a number of respondents thought that was being patronizing totop management and reduced top management's perceived power as sophisticated decision-makers. The second reason given for not using real options is that discounted cash flow is a proven method andtherefore a preferred method. One can hardly blame the respondents for taking an approach that isheavily favored in the literature. The typical procedure in texts and corporate manuals is to downplaymethods such as the payback period and the average rate of return and highlight the superiority of NPVand IRR, which are based on the time value of money and the use of cash flow rather than GAAPearnings. Real option--based books such as Copeland and Antikarov (2001), Amran and Kulatilaka(1998), and Trigeorgis (1996) drew little attention from the nonusers. Many thought they were alreadyusing the normative approach. The third major reason for nonutilization of the real options is that the real options required a highdegree of sophistication. Earlier in the article it was suggested that the greatest utilization of real optionswas in technology, energy, utilities, etc., and that is consistent with the fact that top management inthose industries often have engineering or technology backgrounds. Other industries such as retailing,food processing, and publishing had virtually no utilization of real options. Not only is top management more mathematically sophisticated in certain industries, but lower levelmanagement, which does the initial analysis, may also be more mathematically sophisticated. Anaccounting major or even an MBA may be less likely to engage in mathematically dependent realoption analysis than an engineer or scientist. One respondent said, "Those with a background in the sciences and engineering love the challenges ofdealing with real options. They want to map the decision process and use their mathematical skills toaddress the issues." In order to isolate on the people making decisions, the author inquired about the background of thepeople generally thought to be in control. Distinctions were made between scientific and financial


backgrounds, and a null hypothesis that there is no relationship between the training of decision-makersand the use of real options was tested. The stated hypothesis could be rejected at an alpha level of .05as indicated in part c of the appendix. The fourth reason given for the nonuse of real options is that they tend to encourage excessiverisk-taking. As stated by van Putten and MacMillan (2004) based on their conversations with topexecutives:

For all their theoretical attractiveness as a way to value growth projects, real options have had a difficult time catching on with managers. CFOs tell us that real options overestimate the value of uncertain projects, encouraging companies to over-invest in them. In the worst case, they grant excessively ambitious managers a license to gamble with shareholder's money.

Thus, while real options were initially introduced to make companies morecompetitive by taking on projects that were difficult to evaluate because ofuncertainty, they have taken on a different reputation in the eyes of someexecutives. This is not a point to be taken lightly and requires thatacademics study the practitioner's concerns in a rigorous manner in futurestudies of real options. Some of the resistance could be associated withacademia's lack of understanding of the incentive effects of real options oninstitutional decisions.

Many respondents indicated that whether the methodology is correct or not,there is no assurance that operating managers will actually follow thedecision-making options covered in the initial analysis. While there may bea chance for abandonment in a latter stage of the project, thus recoveringpart of the initial investment (under the use of real options or NPVanalysis), managers at that point in time may have a vested interest inhaving the project continue because they have been identified with it.Discontinuation may even mean recognition of poor earlier judgment and lossof employment. One might suggest that until the corporate culture is changedso that closing down existing operations is rewarded instead of punished,the implementation of the assumptions that are part of the real optionsprocess may not happen.

Both proponents of real options and those who resist them may suggest thatthey are keeping their eye on the ultimate goal of stockholder wealthmaximization. Although Triantis and Borison (2001) maintain that this is oneof the strongest arguments for the use of real options, a chi-squareindependence of classification test indicated there is no relationshipbetween the use or nonuse of real options and the desire to maximizestockholder wealth as indicated in part d of the appendix.

Interestingly enough, those in the financial community where the goal ofstockholder wealth maximization is most widely touted showed little or nointerest in real options. It would appear that until the value of realoptions is included into the valuation models used on Wall Street andelsewhere, there may be little movement in this area of finance.

However, the future for real options in the overall economy is notnecessarily discouraging. As previously stated, 40 of the 279 respondents tothis study (14.3%) are currently using real options. Of the 239 nonusers,43.5% indicate that there is a good chance they will seriously considerusing real options in the future, 15.9% indicate that there is some chance,and only 26.3% totally reject the potential of using real options.

SUMMARY AND CONCLUSION

The inability of classic NPV analysis to capture the future options in acapital budgeting decision is now well documented by Trigeorgis (1993),Copeland and Antikarov (2001), and others. The misuse of classic net presentvalue analysis may understate the value of a potential investment and leadto an incorrect decision, particularly when a high degree of uncertainty isinvolved. Instead of rewarding the asymmetric nature of returns underuncertainty in which future action can allow positive results, classic NPVmay penalize future uncertainty through the risk-adjusted discount rate.

In spite of the points made above, the use of real options by U.S. companiesis limited. From a mailing to the Fortune 1,000 largest companies, 279usable responses were returned. Forty respondents (14.3%) currently used


real options in the capital budgeting process. However, the percentage issomewhat higher than that in prior studies and useful observations can bedrawn from the 40 users and 239 nonusers.

The users come primarily from industries where sophisticated analysis is thenorm, such as technology (13), energy (11), utilities (6), and other similarsegments of the economy. Respondents were divided into 12 major industrialclassifications and a null hypothesis that there is no relationship betweenindustrial classification and the use of real options could be rejected atan alpha level of .01 using a chi-square test.

The Black-Scholes option pricing model was rejected by almost all the usersin preference to such approaches as binomial lattices, decision trees, MonteCarlo simulation, and so on.

The nonusers of real options provide interesting information as well. In atime period in which the normative approach to the capital budgetingdecision is stressed as a key ingredient to stockholder wealth maximization,85.7% of the respondents are not using a valuable tool in the form of realoptions.

The primary reasons given for nonuse of real options in order of importanceare (a) lack of top management support; (b) discounted cash flow is alreadya proven method; (c) real options require too much sophistication; and (d)real options encourage excessive risk-taking.

On a more positive note, 43.5% of the nonusers said that there is a goodchance they will consider the use of real options in the future, 15.9%indicate a positive but less committed response, and only 26.3% totallyreject the use of real options in the future.

APPENDIX

Chi-Square Independence of Classification Tests

Alpha

[chiNull hypothesis square] D.F. .01 .05 .10

a. Use of real options is 27.627 11 24.725 19.675 17.275 independent of industry classification

b. The techniques used 18.268 19 36.191 30.44 27.204 for real options is independent of industry classification

c. Use of real options is 32.197 19 36.191 30.144 27.204 independent of the training of decision-makers

d. The goal of 4.173 3 11.345 7.815 6.251 stockholder wealth maximization is independent of the use of real options

Null hypothesis Conclusion

a. Use of real options is Reject the hypothesis at independent of at .01 level of industry classification significance. Industry classification has a significant relationship to the use of real options

b. The techniques used Accept the hypothesis. for real options is Industry classification independent of does not have a industry classification significant


relationship to technique used

c. Use of real options is Reject the hypothesis at independent of the a .05 level of training of significance. Training decision-makers of decision-makers has a significant relationship to the use of real options

d. The goal of Accept the hypothesis. stockholder wealth The use of real maximization is options does not have independent of the a significant use of real options relationship to the goal of stockholder wealth maximization

REFERENCES

Amram, M. and Kulatilaka, N. (1998) Real options: Managing strategicinvestments in an uncertain world. Cambridge, MA: HBS Press.

Block, S. (2005) Are there differences in capital budgeting proceduresbetween industries? An empirical study. The Engineering Economist, 50(1),55-67.

Canada, J.R. and Miller, N.P. (1984) Review of surveys on capital budgetingevaluation techniques. The Engineering Economist, 30(2), 193-200.

Copeland, T. and Antikarov, V. (2001) Real options: A practitioner's guide,New York: TEXERE LLC.

Gitman, L.J. and Forrester, J.R., Jr. (1977) A survey of capital budgetingtechniques used by major U.S. firms. Financial Management, 6(3), 66-71.

Mao, J.C. (1970) Survey of capital budgeting: Theory and practice. Journalof Finance, 25(2), 349-360.

Ryan, P.A. and Ryan, G.P. (2002) Capital budgeting practice of the Fortune1,000: How have things changed. Journal of Business and Management, 8(4),355-364.

Schall, L.D., Sundem, G.L., and Geigsbeek, W.R. (1978) Survey and analysisof capital budgeting methods. Journal of Finance, 33(1), 281-287.

Scott, D.F., Jr. and Petty, J.W. (1984) Capital budgeting practices in largeAmerican firms: A retrospective analysis in synthesis. Financial Review,19(1), 111-123.

Teach, E. (2003) Will real options take root? Available at: http://www.CFO.com (accessed)

Triantis, A. and Borison, A. (2001) Real options: State of practice. Journalof Applied Corporate Finance, 14(2), 8-24.

Trigeorgis, L. (1993) Topics in real options and applications. FinancialManagement, 22(3), 202-223.

Trigeorgis, L. (1996) Real Options; Managerial Flexibility and Strategy inResource Allocations. Cambridge, MA: MIT Press.

Trigeorgis, L. (2005) Making use of real options simple: An overview andapplications in flexible/modular decision making. The Engineering Eeonomist,50(1), 25-53.

van Putten, A.B. and MacMillan, I.C. (2004) Making real options really work.Harvard Business Review, 82(12), 134.

http://www.CFO.com

http://www.CFO.com


Address correspondence to Stanley Block, M.J. Neeley School of Business,P.O. Box 298530, Texas Christian University, Fort Worth, TX 76129. E-mail:[email protected]

Stanley Block

M. J. Neeley School of Business, Texas Christian University, Fort Worth,Texas, USA

BIOGRAPHICAL SKETCHES

STANLEY BLOCK, Ph.D., C.EA., is professor of finance and holder of theStanley Block Endowed Chair of Finance at Texas Christian University, FortWorth. He is the coauthor with Geoffrey Hirt of numerous books in financeincluding Foundations in Financial Management and Fundamental of InvestmentManagement. The first text has sold over a million copies. He has publishedapproximately 50 articles in such journals as Financial Management, TheJournal of Financial Services Research, Journal of Portfolio Management, TheJournal of Accountancy, The Financial Analysts Journal, The EngineeringEconomist, and the Journal of Finance. He is past president of theSouthwestern Finance Association and a former director of the FinancialManagement Association. He serves as consultant to a number of companiesthroughout the world and has held board of director positions with threepublicly traded companies. At TCU he has twice won the award as theoutstanding instructor in the MBA program.

Table 1a. Characteristics of survey participants:total revenue of survey participants

Number

Under $2 billion 62$2 billion to $4 billions 70$4 billion to $6 billion 38$6 billion to $8 billion 28$8 billion to $10 billion 14$10 billion to $15 billion 23$15 billion to $20 billion 11$20 billion to $30 billion 13Over $30 billion 20 279

Table 1b. Characteristics of survey participants:net profit (loss) of survey participants

Number

Loss 290-$200 million 32$200-$400 million 40$400-$600 million 44$600-$800 million 36$800 million-$1 billion 22$1 billion-1.5 billion 38$1.5 billion-$2 billion 10Over $2 billion 28 279

Table 1c. Characteristics of surveyparticipants: ratio of research anddevelopment to total revenue of surveyparticipants (2005)

Number

0-1% 141-2% 312-3% 673-4% 794-5% 635-6% 176-7% 57-8% 2Over 8% 1


279

Table 2. Primary industry of survey participants (2005)

Number

Beverages 3Energy 25Finance 31Food processing 9Health care 26Manufacturing 57Publishing 5Retail 44Technology 36Transportation 12Wholesale 9Utilities 22 279

Table 3. Types of applications of real options

New product introduction 36.2%Research and development 27.8Mergers or acquisitions 22.1Foreign investment 9.6Other 4.3 100.0

Table 4. Techniques for using real options

Binomial lattices 16Risk-adjusted decision trees 12Monte Carlo simulation 9Black-Scholes option pricing model 1Other 2 40

Table 5. Reasons for not using real options

Lack of top management support 42.7%Discounted cash flow is a proven method 25.6Requires too much sophistication 19.5Encourages too much risk taking 12.2 100%

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real options in real world

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