Real Options Method- Breif Overview

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1. What is Real Options Method? Real Options Method is a valuation method for recognizing different business investment options. It was developed by Black and Scholes and by Merton in the early 1970s. Real options include opportunities to capture best available option for business projects. They are referred to as "real" because they usually pertain to tangible assets such as capital equipment, rather than financial instruments. This method defines the feasible option(not obligatory) to invest. It is the best option when there is high uncertainty. The real options approach focuses on the potential value embedded in exercising the option once the uncertainty has been resolved. Examples of Real Options- * Growth options * R&D * Staged investments; expansion options * Sequential investments (reinvestment, M&A, brands extension) * Contraction options * Abandonment of Project or Division * Contract scale or temporarily shut down 2. Where and under what conditions it is applicable? Though Real Options may offer some intriguing benefits for the appraisal of investment decisions, it has its own limitations and hence should be used judiciously. For e.g., Standard approaches based on the Black-Scholes formula, which are routinely used to value financial options, cannot be applied as a number of conditions are violated. Moreover—although this applies to the DCF approach as well—the assumption must be made that there is a traded security or a portfolio of securities whose risks and payoffs mimic the expected risks and payoffs of the investment project to model future returns. However, the farther we move away from financial markets, the more difficult and costly it is to track an option. Following assumptions are considered in Real Options Method * There is no arbitrage opportunity (i.e., there is no way

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