![]() This is a real option valuation that looks to understand the possible downside and upside values of an opportunity over a set period of time (option life). These are option to delay, option to expand and option to abandon. With real options valuation, innovation leaders can value their opportunities, where applicable, using one of three options approach. As such, real option methodology allows decision makers to structure the right innovation opportunity as an option, one that the owner can either decide to exercise within a certain period of time (option life), if the risks and uncertainty evolve positively and shows the opportunity to be “in the money”, or the owner can chose to walk away from it, if the conditions evolve negatively and shows the opportunity to be “out of the money”. Whilst the traditional NPV approach ignores the value of risk, uncertainty and flexibility, by taking a single focused now or never, go or no-go approach, Real Options Valuation methodology considers risks and uncertainty as opportunities and allows the organisation to exploit the upside whilst rejecting the downside. We will also adopt a much easier to understand, albeit slightly more rigorous binomial model instead of the more complex Black and Scholes replicating portfolio model. In this article, we will introduce real options with a much more granular approach and with examples showing step by step methodology on how to evaluate the real options in different scenarios. Considering the significant impact real options can have for organisations, from both the upside and downside scenarios, we aim to help capital budgeting practitioners (including those sanctioning innovation opportunities) to better understand real options. Low adoption is perhaps due to lack of familiarity and sometimes the complexity of the techniques involved. So how do innovation leaders tackle this problem? The answer lies in Real Options Valuation.ĭespite their ability to uncover hidden value in innovation projects, adoption of Real Options Valuation remain low within innovation, capital budgeting and CFO circles. However, with disruptive and radical ideas or other opportunities with volatility, the method comes up short due to its inability to be flexible and value the inherent uncertainty or risk. This is not so much of a problem for opportunities where there is high certainty and accuracy in these numbers. This methodology implicitly assumes that the estimated yearly cash flows (which are educated guesses at best) are fixed, with the framework having no means of allowing for uncertainty in those values. The DCF & NPV approach is designed as a static methodology, which in addition to the capital investment outlay, considers estimated revenues and costs for each year that the venture will be operating and then applies a risk adjusted discount rate to calculate the NPV. These potential problems emanate from the very nature and attributes of DCF and NPV methodology. False negative is when an innovation opportunity is deemed as economically unviable and thus rejected, but in reality, it actually has positive economic returns. False positive is when an innovation opportunity is deemed as economically viable and thus pursued, but in reality, it is unviable. These are errors of false positive or false negative. However, when leaders are faced with innovations with high uncertainty (disruptive, semi-radical or radical innovation) they often rely on the same metric, which can result in two types of decision making errors. ![]() This metric is however only fairly accurate when dealing with innovations with a high degree of certainty, which is typically aligned with incremental and efficiency innovations. ![]() Generally, the most common and widely used metric for capital budgeting and decision making is the Net Present Value, aided by Discounted Cash Flow. ![]() Corporate leaders frequently have to make decisions on whether to sanction investment in innovations or reject the investment request. ![]()
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