Real Options (Luehrman)

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Treating strategic investments as financial options. Explanation of Real Options of Timothy A. Luehrman. ('98)

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  1. Summary
  2. Forum
  3. Best Practices
  4. Expert Tips
  5. Resources
  6. Print

What are Real Options? Description

Real Options capture the value of managerial flexibility to adapt strategic decisions in response to unexpected market developments. A company creates shareholder value by identifying Real Options, managing of Real Options, and exercising Real Options, associated with its investment portfolio. The Real Options method applies financial options theory to quantify the value of management flexibility, thus turning uncertainty to its advantage in a changing world.


The idea of treating strategic investments as financial options was conceived by Timothy A. Luehrman in two HBR articles: "Investment Opportunities as Real Options: Getting Started on the Numbers" (July-August 1998) and "Strategy as a Portfolio of Real Options" (September-October 1998). In the last article Luehrman says: "In financial terms, a business strategy is much more like a series of options than a series of static cash flows".


Use of Real Options. Benefits

As a result of the above, when valuations involve significant future flexibility or uncertainty and/or future cash-flows alone are close to break-even, flexibility is a major source of value, and option value must be taken into consideration. Note that the first mentioned circumstance is typical for strategic scenarios. And even for strategic decision-making in general.


Formula of Real Options. Calculation

Formula used is Black-Scholes or other similar. Generally, the following variables determine the value of having (an) option(s) - option value:

  • Time to expiration (duration).

  • Degree of uncertainty.

  • Cost of acquiring the option(s).

  • Potential cash flows lost, compared to full upfront commitment.

  • Risk-free interest rate.

  • Expected present value of future cash flows.

By introducing these factors into business decision-making, the Real Options method has enabled corporate decision-makers to use uncertainty for the advantage of the firm, and to create a limit to downside risk.


Real Options Forum
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  Real Options Applied to Rapid Labour Mobilization
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  Applicability of Real Options in Oil and Gas Field Development
How to use the real option technique for the appraisal of oil & gas field development projects?...
     
 

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Best Practices - Real Options Premium

Expert Tips - Real Options Premium
 

How to Become a Self-tuning Enterprise: Advanced Experimenters

In an HBR article of June 2015, Reeves, Zeng and Venjara argue there's a new way to apply algorithmic principles that enables organizations to constan...
Usage (application): Organizational Agility, Strategic Agility, Real Options, Emergent Strategy
 
 
 

How to Design Experiments to Support Decision-making on Strategic Innovations

The probability of success of a major innovation is difficult to assess. Statistics and other datasets only provide information about past beha...
Usage (application): Strategic Innovation, Strategic Decision-making, Strategic Experimenting, Experiments, Strategic Testing, Innovation Tes
 
 
 

How to Link Risk Management and Strategy?

Firms practicing strategic risk management:
1. Create value by embracing risks, shaping risks, and exploiting flexibility to deliver uniqu...
Usage (application): Strategic Risk Management, Best Practices
 
 
 

Align Strategy and Risk Management

In a recent white paper titled "Foundations of GRC: Enhancing Business Performance Through Risk Management", which was published by Corporate Integrit...
Usage (application): Performance-Aligned Risk Management
 
 
 

Taking Risk Management from Control and Compliance into a Competitive Advantage

Since events tend to be repetitive over time, many management experts support the idea that an effective risk management policy strongly takes into...
Usage (application): Strategic Risk Management
 
 
 

Why Society is More Risky than Before

In his 1992 book "  
 
 

Real Options and Brand Value

A brand can be considered as a feature that allows a firm to gain a unitary profit margin higher than those of products without any brand, and a highe...
Usage (application): Exploiting Real Options
 
 

Resources - Real Options Premium

Scenario Planning and Risk Management in Uncertain Business Enviroment

Extensive and detailed presentation.
Topics:
- Integrated Risk Management Framework
- Strategic Management Framework
- History of ...
Usage (application): Scenario Planning, Risk Management, Strategic Uncertainty
 

Important Issues Involving Real Options

This paper by Gordon Sick and Andrea Gamba provides an introduction to real options, as well as highlights some important issues that are often neglec...
Usage (application): Real Options, Capital Budgeting
 

The Six Basic Questions of Risk Management: Introduction to Risk Management

Managing risk is essentially a process of asking and answering six relatively easy questions no matter what setting (personal, business, etc) or situa...
Usage (application): Initial Understanding of Risk Management, Risk Management Introduction
 

Financial Flexibility Option

This model estimates the value of financial flexibility, i.e, the maintenance of excess debt capacity or back-up financing. By Aswath Damodaran....
Usage (application): Valuing financial flexibility
 

Delay Option

This model estimates the value of the option to dealy in an investment project. By Aswath Damodaran."...
Usage (application): Valuing delay option
 

Expand Option

This model estimates the value of the option to expand in an investment project. Modified, it can also be used to assess the value of strategic option...
Usage (application): Valuing expand option
 

Rules of Thumb in Real Options Analysis

In this normative paper, Giuseppe Alesii derives payback period (PBP) and internal rate of return (IRR) in the presence of real options. In a Kulatila...
Usage (application): Real Options Analysis
 

Abandoning Option

This model estimates the value of the option to abandon a project or investment. By Aswath Damodaran....
Usage (application): Valuing abandoning option
 
 

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Compare with: Scenario Planning  |  RAROC  |  Strategic Risk Management  |  PEST Analysis  |  Analogical Strategic Reasoning  |  Root Cause Analysis  |  CAPM  |  Dialectical Inquiry  |  Plausibility Theory  |  Theory of Constraints  |  Operations Research


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