Evaluating real options as a means for investment appraisal under uncertainty and its degree of utilisation by companies

Diploma Thesis from the year 2003 in the subject Business economics - Investment and Finance, grade: 1,0, Aachen University of Applied Sciences (Wirtschaft), language: English, abstract: Inhaltsangabe:Abstract:§This paper evaluates the real options approach (ROA) as a means for appraising capital investments under uncertainty. Globalisation and growing competitiveness have led to an increase in uncertainty with regard to companies decision making. Flexibility to react to this uncertainty has become more important. The question arises whether there is a need for a further investment appraisal technique or whether traditional techniques can cope with that. A growing literature about real options shows that traditional investment appraisal techniques do not value flexibility. That is why ROA has become more important within recent years. However, the degree of its utilisation by companies seems to be rather low. Three possible reasons for that are examined:§ROA is not well-known by companies, especially small- and medium-sized enterprises.§ROA is only limitedly applicable.§ROA is too difficult to use.§After traditional investment appraisal techniques have been outlined, the real options approach is illustrated by means of a case study. The possible range of application is assessed by reviewing the literature. A survey was conducted to check whether companies know about or apply that technique, and to identify the tools used by companies.§This study shows that while the range of possible applications of real options is rather vast, ROA is rarely known by German and British companies and barely applied. One reason might be, that most books and articles are of rather academic nature. This seems to have been realised since books with a focus on practical application have been published recently. The complexity of ROA seems to be a further reason for its low degree of utilisation. Companies tend to use simpler but more comprehensible techniques although these methods have some major drawbacks. However, business science should not end in itself but serve businesses. Therefore, further emphasis has to be put on making real options approachable for practitioners.§Inhaltsverzeichnis:Table of Contents:§I.Abstract2§II.Acknowledgements3§III.Table of Contents4§IV.List of Figures7§V.List of Abbreviations8§1.Introduction9§2.Characteristics of Investment Decisions11§2.1What Is a Capital Investment?11§2.2Risk and Uncertainty12§3.Tools for Investment Appraisals15§3.1Static Methods15§3.2Discounted Cash Flow Approaches (Dynamic)17§3.3Approaches Which Try to Deal With Risk20§4.The Real Options Approach24§4.1Why Use Real Options to Evaluate Capital Investments?24§4.2Financial Options26§4.3Real options explained by using a case study34§4.4Real Option Examples in Literature and Practical Applications46§4.5Advantages and Deficiencies of Real Options51§5.Survey57§5.1Methodology57§5.2Evaluation of the Results59§5.3Discussion of Problems of the Survey and Relevance of the Findings66§6.Conclusion - Is the Real Options Approach Really Necessary?69§VI.Appendix73§1.Example of What Is Risk73§2.Bounding the Value of an Option73§3.Put-Call-Parity75§4.Derivation of Binomial Option Pricing Formula77§5.Derivation of risk-adjusted discount rate79§6.Questionnaire80§7.Used tools dependent on size of the company88§8.Excel sheets for case study89§VII.References108