Real options theory has become an influential explanatory and normative framework for making resource allocation decisions. Despite a growing body of strategy research regarding real options, however, there is as of yet little empirical confirmation (1) that firm resource allocation behavior conforms with real options theory, or (2) that employing real options principles has a positive impact on firm performance. This research examines these questions. Using a survey instrument designed to measure a range of real options-theoretic decision patterns, data has been collected from a sample of 173 U.S. manufacturing firms. This data set has been used to test two central premises. The first is that, in contrast to much of the real options literature, there is no inherently superior real options decision pattern. Instead, real options-optimal investment decisions depend on the magnitude and source of the uncertainties that firms encounter in their task environments. This premise is tested by measuring two important sources of uncertainty in the external environment: uncertainty regarding the level and composition of demand (market uncertainty) and uncertainty regarding the intentions and actions of competitors (competitive uncertainty). I develop the theoretical foundation for expecting that patterns of real options behavior vary with these two sources of uncertainty, and that different sources of uncertainty frequently promote competing real options-theoretic decision behavior. The research tests these hypothesized relationships empirically. The principal contribution of this analysis has been to develop a more fine-grained appreciation of the relationship between real options theory and a multidimensional conceptualization of uncertainty. The second premise of the research is that making investment decisions based on real options principles has a positive effect on firm performance. There is ample theoretical foundation for the superiority of real options theory as a framework for making resource commitment decisions. The research examines this expectation empirically by testing whether the fit or congruence between real options decision patterns and environmental uncertainty is positively related to firm profitability, market value and growth.

Yes / We derive the optimal investment timing and real option value for a facility with price and quantity uncertainty, where there might be a government subsidy proportional to production quantity. Where the subsidy is proportional to the multiplication of the price and quantity, dimensionality can be reduced. Alternatively, we provide quasi-analytical solutions for different quantity subsidy arrangements: permanent (policy is certain); retractable; suddenly permanent; and suddenly retractable. Whether policy uncertainty acts as a disincentive for early investment depends on the type of subsidy arrangement. The greatest incentive for early investment is an actual retractable subsidy, a ‘flighty bird in hand’.

This dissertation assumes the R&D investment future cash flows of a firm which follows an arithmetic Brownian motion and Poisson (jump) process. This study evaluates the R&D investment decisions under different market structure while considering the stochastic impact scales are the normal, negative exponential, and Laplace distributions, respectively. The first model of this dissertation aims to build monopoly R&D investment decisions under different stochastic impact scales. The result of this study is different from Cossin et al. (2002), since it shows that the outcome of Cossin et al. (2002) has underestimated decision values in assessing lump-sum investment, staging investment, and liquidation decisions. Sensitivity analysis reveals the following: (1) the positive relation parameter for the lump-sum investment is the cash flow growth rate of project, frequency of jump event, time of jump event, mean and deviation of normal distribution, and initial cost. (2) The positive relation parameter for liquidation decisions is the cash flow growth rate of project, frequency of jump event, time of jump event, and mean and deviation of normal distribution. The second model of this dissertation extends the monopoly to duopoly, and it aims to build the duopoly R&D investment decisions under different stochastic impact scales. The result of the study accords with Tsekrekos (2003) that with more uncertainty, there are more duopoly investment thresholds. Sensitivity analysis reveals the following: (1) the positive relation parameter for the leading R&D investment thresholds is deviation, frequency of jump event, discount rate, investment cost, and mean and deviation of normal distribution, while the negative relation parameter is the growth rate and market share. (2) The positive relation parameter for the follower R&D investment thresholds is deviation, market share, frequency of jump event, discount rate, investment cost, and mean and deviation of normal distribution, while the negative relation parameter is the growth rate. The third model of this dissertation extends to oligopoly, and it aims to build the oligopoly R&D investment decisions under different stochastic impact scales. The result of the study accords with the expectancy of Grenadier (2002), that while other things being equal, the more industry's competition degree, the lower oligopoly investment thresholds. Namely the higher the numbers of firms in an industry, those oligopoly firms have more incentives to invest early. Sensitivity analysis shows the following: (1) The positive relation parameter for the oligopoly R&D investment thresholds is deviation, frequency of jump event, discount rate, unitary investment cost, and mean and oligopoly supply, while the negative relation parameter is the growth rate and market share. (2) The negative relation parameter is the number of firms in the industry, growth rate, and demand elasticity.

Real options have been widely applied to analyze investment planning and asset valuation under uncertainty in many industries, especially energy markets. Because of their close analogy to financial options, real options can be valued using the classical financial option pricing theories and their extensions. However, as real options valuation often involves complex payoff structures and operational constraints of the underlying real assets or projects, accurate and flexible methods for solving the valuation problem are essential. This thesis investigates three different approaches to real options valuation and contributes to aspects of modeling realism and computational efficiency. The contributions are illustrated through two important applications of real options in energy markets: natural gas storage and power plant valuation. Because spread options are commonly used in basic real options valuation techniques, the first part of the thesis addresses the problems of spread option pricing and hedging. We develop a new closed-form approximation method for pricing two-asset spread options. Numerical analysis shows that our method is more accurate than existing analytical approximations. Our method is also extremely fast, with computing time more than two orders of magnitude shorter than one-dimensional numerical integration. Closed-form approximations for the Greeks of spread options are also developed. In addition, we analyze the price sensitivities of spread options and provide lower and upper bounds for digital spread options. We then further generalize the above results to multi-asset spread options on an arbitrary number of assets. We provide two new closed-form approximation methods for pricing spread options on a basket of risky assets: the extended Kirk approximation and the second-order boundary approximation. Numerical analysis shows that both methods are extremely fast and accurate, with the latter method more accurate than the former. Closed-form approximations for important Greeks are also derived. Because our approximation methods enable the accurate pricing of a bulk volume of spread options on two or more assets in real time, it offers traders a potential edge in a dynamic market environment. In the third part of this thesis, we propose a market-based valuation framework for valuing natural gas storage facility with realistic operational characteristics. The operational process is modeled as a multi-stage stochastic optimization problem. We develop a Gaussian quadrature scheme to solve for the dynamically optimal spot trading strategy and show that the computational efficiency of this method exceeds existing approaches in about two orders of magnitude. Furthermore, with this flexible quadrature scheme, we propose to value a gas storage based on a novel hybrid trading strategy that successfully incorporates both spot and forward trading, thus improving the storage valuation significantly by accounting for both the inter-month and intra-month operational flexibilities and price volatility. In the fourth part of this work, we develop a continuous-time formulation for power plant valuation in infinite time horizon. We propose a real-option-based model for a power plant to account for the embedded operational flexibility. This model incorporates start-up and shut-down costs as two major operational constraints. Under this continuous valuation model, spark spread is modeled directly as a continuous stochastic process to take account of the long term co-integration relationship between electricity and fuel prices. Instead of discretizing the stochastic process, we preserve continuity of the stochastic spark spread process and work directly with the value function. Closed-form of value function under threshold policy is obtained. The corresponding optimal operational strategy can then be solved. The advantage of this approach is that it reduces computational complexity while incorporates major operation characteristics. It enables fast computation of a power plant value that approximates the real market value and sensitivity analysis of the asset value with respect to the cost parameters of a power plant and the distribution parameters of spark spread.

Thesis (MBA)--Stellenbosch University, 2004. / ENGLISH ABSTRACT: The following study project was written by the author in the scope of his MBA Program at the University of Stellenbosch. While the number of articles and books that deal with the theory of real options is extremely large, the use of real options as a valuation tool is not widely accepted in practice. The reason for this obvious discrepancy is the fact that these papers and the models developed therein are highly mathematical and require a thorough knowledge of statistical methods. There are few papers or books that explain the fundamental ideas and basic techniques in such a way that general managers are likely to be convinced that real options valuation is an interesting and valuable tool. The purpose of this study project is to fill this gap, to bring the theory of real options closer to a wider range of people and to make it comprehensible for people who have not studied mathematics or finance. To achieve this aim the study project consists of four parts. Recalling the well-known concept of financial options, the first part explains in detail the basic idea of real options theory. The second part deals with the different existing models that are used to determine the value of real options. However, the focus lies on the comprehensibility of these models and not on the pure mathematical side. In the third and main part of this thesis the different variables that are needed for evaluating real options are discussed and methods to determine realistic values of these variables are explained. Some recommendations will be made as to what one ought to focus on in determining the variables. A valuation with "real" data is discussed in the fourth part. / AFRIKAANSE OPSOMMING: Die werkstuk is in die loop van die outeur se MBA-kursus aan die Universiteit van Stellenbosch voltooi. Die aantal bronne en artikels wat betrekking het op die teorie is eindeloos, terwyl die werklike opsies nog nie wyd aanvaar word in die praktyk nie. Die rede vir die ooglopende verskil is die feit dat die artikels wat betrekking het op die teorie en modelle hoogs wiskundig is en 'n deeglike kennis van statistiek vereis. Daar is tans 'n tekort aan artikels en boeke wat die fundamentele idees en basiese tegnieke van reële opsies verduidelik/oordra op so 'n manier dat dit deur algemene bestuurders gebruik kan word. Die doel van die werkstuk is om hierdie probleem te oorkom deur reële opsie valuasies aan 'n wyer gehoor bekend te stel wat nie 'n wiskundige of finansiele agtergrond beskik nie. Om bogenoemde doelwit te bereik, word die werkstuk in vier dele opgedeel. Die eerste deel verduidelik die basiese beginsel van reële opsie teorie in groot detail. Die tweede deeI dek die verskillende modelle wat tans gebruik word om reële opsies te waardeer. Die fokus Iê egter op die verstaanbaarheid van die modelle en nie noodwendig die wiskundige onder bou nie. In die derde en kerndeel van die verhandeling word die verskillende metodes om reële opsies te waardeer, bespreek, asook die maniere om realistiese waardes volgens verskillende metodes te vind. 'n Waardasie met werklike data word in die finale deel aangebied.

published_or_final_version / Real Estate and Construction / Master / Master of Science in Real Estate and Construction

This study aims to explore how banks evaluate investment decisions towards SMEs, through a real option approach. After analyzing 9 interviews with business advisors from four different banks, illustrations show that banks indeed use a real option way of thinking, without being aware of it as well as put more weight in certain factors namely the repayment ability. Moreover, the relationship factor shows an interesting relevance during investment evaluation towards SMEs, as better relationships lead to lower demands on factors of evaluation. In brief, the study contributes to the theory of real options as well as of practical essentiality to banks and SMEs.

Military acquisition programs have long been criticized for the exponential growth in program costs required to generate modest improvements in capability. One of the most promising reform efforts to address this trend is the open system architecture initiative, which uses modular design principles and commercial interface standards as a means to reduce the cost and complexity of upgrading systems over time. While conceptually simple, this effort has proven to be exceptionally difficult to implement in practice. This difficulty stems, in large part, from the fact that open systems trade additional cost and risk in the early phases of development for the option to infuse technology at a later date, but the benefits provided by this option are inherently uncertain. Practical implementation therefore requires a decision support framework to determine when these uncertain, future benefits are worth the cost and risk assumed in the present. The objective of this research is to address this gap by developing a method to measure the expected costs, benefits and risks associated with open systems. This work is predicated on three assumptions: (1) the purpose of future technology infusions is to keep pace with the uncertain evolution of operational requirements, (2) successful designs must justify how future upgrades will be used to satisfy these requirements, and (3) program managers retain the flexibility to adapt prior decisions as new information is made available over time. The analytical method developed in this work is then applied to an example scenario for an aerial Intelligence, Surveillance, and Reconnaissance platform with the potential to upgrade its sensor suite in future increments. Final results demonstrate that the relative advantages and drawbacks between open and integrated system architectures can be presented in the context of a cost-effectiveness framework that is currently used by acquisition professionals to manage complex design decisions.

This thesis is dedicated to a new method of investment evaluation -- real options. The main goal is to simplify the method of real options. This objective is composed of three sub-secondary objectives: the classification of the various valuation methods, focusing on their benefits and pitfalls of practical application, simplifying the mathematical tools for calculating real options and applying the method of real options in the Czech Republic. The authors made use of both printed and electronic sources of information. The benefit of this work is that these resources come from three languages - Russian, Czech and English. The main scientific methods which were used in this thesis are analysis, synthesis, and mathematical-statistical methods. Work is intended for a narrow circle of readers dealing with the evaluation of investments.

Dans la mesure où les environnements économiques et financiers sont régis par de nombreux aléas, la prise de décision en matière d'investissement immobilier s'avère de plus en plus complexe.Le premier chapitre commence par présenter les méthodes traditionnelles d'évaluation des choix d'investissement dans le secteur immobilier. La notion d'option réelle est ensuite introduite au travers du lien entre les options réelles et les options financières. Le deuxième chapitre s'intéresse à différents cas de recours aux options réelles dans le secteur immobilier en faisant systématiquement référence à la littérature qui leur est consacrée. Le troisième chapitre présente des analyses de mesure de la performance et de dynamique des rendements et de volatilité sur les marchés européens et américains. / As the economic and financial environments are governed by many uncertainties, decision-making on real estate investments is becoming increasingly complex.The first chapter begins by presenting the traditional methods to value real estate investments. The concept of real options is then introduced through the link between real options and financial options. The second chapter focuses on different use cases of real options in the real estate industry by referring to the literature devoted to them. The third chapter presents a performance measurement analysis and a study of the dynamics of returns and volatility in European and American markets.