Real Options:Does Theory Meet Practice?

Professor Alexander J. Triantis

Evolution of RO: Theory and Practice

• Theory– Over 750 papers during the last 20 years – Accelerating research productivity– Interdisciplinary research area

• Practice– Took off in the mid-1990s– RO usage at around 10%? – High attrition rate?

New Insights and a New Vocabulary

• Key insights:– Reactive and proactive management– Redesigning processes – Transacting in flexibility– Risk-return issue is complex

• Management– Transformational insights– Insights confirmed, and new vocabulary

Killer Aps

• Natural Resources, R&D, Manufacturing, M&A, and Infrastructure

• Some common characteristics– Large investments, low/no up-front cash flow– High uncertainty, but available data– Structured series of stages– Engineers and scientists

Real Options in the Crosshairs

• The internet bubble and Enron

• “Old Wine, New Bottles”

• Need to model reality, not perfection

• The “extreme sport” view of real options

RO

Agenda for Research

• Perfecting the models of perfection

• Splitting options

• Modeling managerial behavior

• Developing heuristics

• Valuing and managing the firm

Perfecting the Models of Perfection

• Modeling and Estimating Distributions– mean-reversion, jumps, stochastic parameters

• Pricing risk– commodity-based applications– underlying project comparables

• Powerful Computational Techniques

Splitting options

• Most real options not held exclusively or completely by a single company

• Split across competitors– wide range of assumptions and models

• Split along value chain– contract design to get to first-best solution

Modeling Managerial Behavior

• Tools don’t make decisions, people do!• Two key issues

– Cognitive biases– Managerial incentives

• Estimate sub-optimal behavior• Alter the behavior

– Good luck vs. good decisions?

• RO Twist: Flexibility can be misused

Developing Heuristics

• Accuracy vs. Simplicity– Simpler models are more likely to be used– Complex models can be used as benchmarks

• Heuristics– NPV w. WACC; higher hurdle rate– Enables the technology transfer

• Software - framing, computations, graphs

Valuing and managing the firm

• Managers respond to analysts’ metrics

• All the other four pieces need to be in place+ Modeling project interactions+ Effects of capital structure and risk management

• Goals• Internal management and valuation• External valuation

Going Forward

• Adoption of real options– organizational factors– quality and simplicity of tool

• Real options Capital budgeting– NPV special case– no longer a “supplementary” tool

• Responding to critiques essential to bridging gap between theory and practice