Exploring the Effectiveness of Real Options

Introduction1

Discussion1

1. Real Option applied by Mobitel1

1. a. Significant Outcomes for the First Company3

2. Real Option applied in Real Estate Company3

2. a. Difference between both Cases4

Conclusion4

References6

Exploring the Effectiveness of Real Options

Introduction

Whenever an organization goes for expansion or product development it needs to utilize invest appraisal techniques, these appraisal techniques vary from each other on the basis of factors that they highlight or address. In earlier time NPV rule were considered as basis for making investment decisions. However, recent developments in the landscape of corporate finance have developed a novel approach for investment appraisal known as Real Options (RO).

This report elucidates the concept of real options, and it also provides a comparison between two organizations (Mobitel & Real Estate Company) that has utilized the real option techniques in making investment decisions.

Discussion

Term real option is derived from a Late Latin word “realis”, which means immovable, fixed or permanent thing. (Mun) in 2012 states that real options are going to replace NPV (net present value) as core paradigm for investment decisions. Empirically it has been proved that RO valuation models generate more positive and appropriate capital budgeting results or recommendations as compared to Net present value rule (Jason, et, al., 2012).

1. Real Option applied by Mobitel

This part analyzes an investment decision that represents the effectiveness of real option in determining the optimal investment or entrance timings. Mobitel, world's renowned telecommunication operator was not clear in making decision reading the deployment of 3G (third generation) mobile network. People at high echelons of Mobitel were highly confused regarding this decision because their major competitor “Comptel” had already acquired 3G license. Decision related to right entry time was quite difficult because it required a tradeoff between flexibility & commitment (Charlotte & Bertrand, 2010). This increasing level of puzzlement and confusion created an opportunity for the adaptation of financial models (real option techniques). The strategic decision was whether the network rollout should start immediately or the decision to deploy the 3G network should be deferred by one year. Mobitel's top management was torn between the risk of investing massive sunk costs in a technology that would not be profitable and the risk of being preempted by its competitor, Comptel.

Real option model offer analyst with 2 types of information; 1) actual value of option, 2) most optimal or suitable time for exercising the option. This decision or opportunity of Mobitel was best analyzed by an option lens. RO analysis assist Mobitel in determining that it is not feasible to deploy 3G on immediate basis, as defer deployment was indicating better position as shown in the table given below

Valuation of Underlying Opportunity (3G deployment) via Real Option technique

Parameters for a valuing Financial Option

Application to Mobitel's Investment Project

Value in monetary Units

Price of underlying asset (S)

Cash flows generated by 3G mobile network

50% 1078 + 1227 = 1152 MU

Exercise price (K)

Investment cost necessary to deploy 3G network

1120 MU

Time to expiration (T)

Period during which the investment can be postponed

1 year

Risk free rate in ...