“Spotting real options embedded in an investment project is far more important than valuing them,” remarked Associate Professor Charlie Charoenwong from Nanyang Technological University. He gave a talk at Sasin’s Research Seminar on February 13 based on “Investment Opportunities as Real Options” written by Timothy A. Luehrman (Harvard Business Review, 1988, pages 51 – 67). Dr. Charlie stated that the NPV is not designed to capture the value of real options. Identifying the real options is usually based on intuition rather than conscious reasoning, something that an MBA student, who is more prone to deliberate thinking might miss. “Although [businessmen] they may not have formal education, they have instinctive understanding to discover real options,” he remarked. Based on the example in Luehrman’s article, Franklin Chemical, a company specializing in processing chemicals, considers building a new plant to exploit its innovations in technology. The NPV analysis shows that the new plant investment project would create essentially zero value. Further investigating reveals that the apparent zero NPV stems from failing to incorporate the value of an expansion opportunity, that is a real option embedded in the investment project. The exercise delved into Franklin Chemical’s cash flow projection, incorporating factors such as a discount rate of 12 percent, cash flow growth of 5 percent, and a tax rate of 34 percent. Detailed calculation revealed an upfront capital expenditure of $100 million for the initial investment, seemingly discouraging at first glance. After considering depreciation and tax benefits, a single huge amount of a future cash outflow was noticeable. Luehrman emphasized that from a real options perspective, Franklin Chemical’s expansion in the later stage represents a strategic option rather than a mere investment commitment. Despite the NPV hovering around zero, the future expansion provides the company with strategic flexibility, enabling it to seize future growth opportunities in dynamic market conditions. By recognizing the underlying asset value of Phase 2 (i.e., expansion) and embracing strategic flexibility, companies like Franklin Chemical can navigate uncertain business environments more effectively, capitalize on emerging opportunities, and enhance long-term value creation. In summary, Dr. Charlie raised three points when evaluating a large investment project:

1. Identify real options: This task is the most important. You should always plot the free cash flow of a project on a bar chart. A big spike of a cash outflow on the chart likely reveals a future capital expenditure which may imply an expansion option.
2. Remember that the value of an option cannot be negative.
3. Value an option: If an explicit valuation is needed, apply the Black-Scholes Option Pricing Model.

“When you hold an option, you always have a non-negative value. Therefore, the moment you spot a real option embedded in an investment project, the NPV of the project is underestimated,” said Dr. Charlie. “To value the real option by the Black-Scholes equation, it is relatively a simple task since most information is available in the project analysis.” Dr. Charlie’s insights offer a paradigm shift in investment evaluation, emphasizing the importance of recognizing and valuing strategic options beyond traditional metrics like the NPV. By embracing real options strategy and employing practical methodologies, organizations can navigate uncertain environments more adeptly, capitalize on hidden opportunities, and enhance long-term value creation.