RealOptionsACriticalReview-AnnualInternationalReal.docVIP

Real Options Analysis: Where are the Emperor’s Clothes? Adam Borison Stanford University 05/17/03 DRAFT Abstract In the more than 25 years since the term “real options” was coined by Stewart Myers, several approaches have been proposed for calculating the real option value of a potential corporate investment. Unfortunately, the assumptions underlying these various approaches and the conditions that are appropriate for their application are often not spelled out. Where they are spelled out or can be inferred, they differ widely from approach to approach and are even contradictory. Furthermore, the difficulties in implementing the different approaches are rarely discussed, and the pros and cons of alternative approaches are not explained. This paper attempts to help remedy this situation by describing, contrasting, and…yes…criticizing the major proposed analytic approaches for applying real options, typically termed “real options analysis” or “real option valuation.” The emphasis is on three fundamental issues surrounding each proposed approach: Applicability: what does the calculated real option value represent, and where is it appropriate to use this calculation? Assumptions: what are the notable assumptions underlying the approach, and what is the evidence regarding the validity of these assumptions? Mechanics: what steps are involved in applying the approach, and what are the associated difficulties? The paper concludes with observations about the relative strengths and weaknesses of the proposed approaches, and specific recommendations on which ones to use in what circumstances. 1. Introduction The term “real options” was coined by Stewart Myers in 1977. It referred to the application of option pricing theory to the valuation of non-financial or “real” investments with learning and flexibility, such as multi-stage RD, modular manufacturing plant expansion and the like. (Myers, 1977) The topic attracted moderate, primarily academic, interest in the 1980’s