The discretionary nature of option payoffs gives rise to an asymmetry in firm outcomes. Certain rights may be established through contracts (e.g., options to acquire a JV partner’s stock, patents) or through specific knowledge obtained by the firm (e.g., through R&D or a strategic acquisition). The outcome of exercising the decision right is asymmetric as the decision maker can take the future action only if it is beneficial, but not otherwise. Tangible or physical real assets underlying real options might include R&D and patents land or real estate natural resources, such as oil, gas, or mineral reserves manufacturing plants and strategic acquisitions intangibles include brand and reputation, unique business processes, flexible human capital, and knowledge developed in joint ventures or other cooperative agreements.Ī (real) option gives the right, but not the obligation, to take a specific future action (e.g., to invest) at a specified cost. Real options theory has thus extended options thinking (and methods) from the financial markets, where options are based on tradable contracts with specified terms, to real assets, tangible or intangible. But whereas in the case of financial options the investor has the right to acquire (or sell) a financial asset (e.g., shares of stock) as the underlying security, in real options the underlying is a “real” asset whose expected future cash flows are linked to new product development via investing in an R&D program or the exploitation of a patent, the construction and subsequent scale up of a manufacturing plant in the home country, new foreign market entry and the growth or shifting of foreign subsidiary operations within the network of a multinational company (MNC), and so forth. These terms depend on adjustment (or switching) costs, imperfect competition or other imperfections in product or factor markets. Real options are seen as opportunities (without an obligation) to acquire (dispose or reposition) real assets on possibly favorable terms. Real options theory brings the theory of financial options from the capital markets to the realm of corporate investment decisions and strategic decision making under conditions of uncertainty.
Managerial flexibility manifests in terms of a set of corporate real options on whether to defer or stage investment, expand or grow, contract, abandon and switch use, or otherwise alter a capital commitment. Real options theory analyzes the value of managerial flexibility to adapt and revise future decisions to capitalize on favorable future investment opportunities or to limit downside losses from adverse market developments, which is vital to long-term corporate success in an uncertain and changing marketplace.
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