EXECUTIVE SUMMARY
Real options represent the application of option-pricing models to the valuation of strategic investment opportunities where future decisions can be made contingent on the resolution of uncertainty. In essence, the models capture the value of managerial flexibility in making strategic decisions, such as the option to defer, expand, contract, or abandon a project, depending on evolving market conditions.
In valuation theory, real options address limitations of traditional discounted cash flow (DCF) models by accounting for uncertainty and providing a more dynamic framework. While DCF assumes a static investment decision, real options recognize that managers can adapt to new information, thus creating additional value. The underlying methodology often relies on techniques such as binomial lattices, Black-Scholes formula, and Monte Carlo simulations to model these contingent decisions. Note that the above option pricing models were originally developed in corporate finance to value derivative financial instruments (e.g. stock options), not to assess other real-life investment decisions.
Expanded application of option pricing models to real-life investment and other similar decisions is beneficial given the robust valuation techniques developed in estimating fair value of options. By building appropriate analogies, such techniques can be applied to instances beyond valuation of options and other derivatives.
Besides certain investment decisions covered in a standard corporate finance textbook (e.g. option to abandon or expand investment project), we document application of option pricing theory to contingent purchase consideration, warrant with a put option and, more generally, relations between equity and asset value. All such applications represent, in a broader sense, examples of real options.
Our documentation of application examples in the publication is performed at a summary level.