Real option approach to business valuation

Seminar Paper, 2013
16 Pages, Grade: 1,6



List of abbreviations

List of Figures

List of Tables

1 Introduction

1.1 Problem and Objective

1.2 Procedure

2 Integrating the real options approach to business valuation

2.1 The real options approach

2.2 Classification of real options

2.2 Demarcation between real options and financial options

3 Of Real Option

3.1 Decision tree method

3.2 Rating with the binomial model

4, The real options approach to the review corporate practice



List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

List of Figures

Abbildung in dieser Leseprobe nicht enthalten

List of Tables

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

1.1 Problem and Objective

There are various events to which a company valuation must be created. For the valuation of companies, various valuation methods are available. Most of these approaches are static calculation methods such as the discounted cash flow method. This method is one of the static corporate policies. The response to newly acquired information can not be taken into account and therefore lead to lower ratings from this approach and all other static approaches. This is especially true for young, innovative and dynamic company.1 To better match the DCF method to the uncertain development of the future, various scenarios can be simulated with different parameters. Nevertheless, there is a reporting date and the mutual influence of the variables can not be adequately represented.

The real options approach, which was originally used only for the investment calculation can, also be applied to companies because the company valuation represents a special case of investment analysis.2 In the boom times of the new economy around the turn of the century was said to have the ROA that it would be a concept that justifies artificially increased corporate values.3 For this period, the most of literature that deals with the real options approach comes from.

With the ROA no independent valuation method is presented, but an extension of the familiar discounted cash flow method. The crux of the extension is the evaluation of action flexibilities in the otherwise static method.4

The aim of this study is to investigate the real options approach for its suitability as a business valuation method and to identify its strengths and weaknesses.

1.2 Procedure

In Chapter 2, the ROA is explained. It follows the idea of three selected real options: the growth option, the waiting option, and the option to abandon (2.2). Following similarities and differences between financial options and real options are shown (2.3). Chapter 3 deals with the evaluation of RO using the decision tree method and the binomial model. In Chapter 4, the difficulties of the RO-evaluation process are presented in practice. The last chapter concludes with an outlook.

2 Integrating the real options approach to business valuation

2.1 The real options approach

Real Options (Engl. Real Options) are an entrepreneurial leeway within an investment project.5 The term was first coined by Meyer's 1,977th6 Leithner and Liebler define a real option as "[...] the right and not the obligation to exercise (flexibility), the economic attractiveness is ex ante not one-dimensional set (uncertainty) and the option right is offset by the exercise (irreversibility)."7 This definition is also applicable to a financial option.

The use of this room for maneuver must be carried out immediately. It is possible to make the decisions on the use in the future. We then speak of temporal flexibility.8 If future development is uncertain, postponing a decision represents an increase in value as new information can be gained over time. A characteristic of real options is the asymmetric payout profile, which manifests itself in the increase of profit potential and minimize risk of loss.9 This asymmetry lies in the fact that it is possible in the case of unfavorable conditions not to exercise the option. The loss is thus limited to the option price.

To use the ROA for the company valuation, either the entire company be seen as an option or is an evaluation of individual business projects. The value of the individual projects is then added to a detected by the DCF method corporate value added.10

2.2 Classification of real options

There are a number of real option types in the literature. Here are three types of options are exemplified.

The growth option (growth option) includes the ability to enter into new business or to develop new markets. An extension option, however, describes the ability to perform follow-up investments to expand a base investment. Expansion options provide an explanation for why companies enter into investments that are rejected for the DCF viewing out. but they are still so conducted a follow-on investment is possible. Companies refer to this as the likes of strategic potentials.11 Compared to a financial option is a compound option, that is an option on an option or composite option.12

The wait option (option to Wait) makes it possible to postpone an investment if the chances of success are uncertain at the status quo. The advantage that the company can generate with this option is information growth. On the basis of external macroeconomic environment, the company can decide whether it carries out the investment or not. The waiting option is similar to a call option American type.13 One bezeichtnet the waiting option as learning, delay or deferral option.14

The termination option (Option to Abandon) provides management the ability to cancel investment projects before completion and liquidate existing assets at an agreed price. This option types the release already invested money in the foreground and not prevent future capital expenditures, the potential sunk costs is present. Transferred to contracts of sale, this may be involve withdrawal rights and guarantees.15 Compared with financial options, the option to abandon a put option corresponds.16

2.2 Demarcation between real options and financial options

Real options are often explained on the basis of financial options, because both are based on three constitutive properties. An analogy is given when the structures of cash flows similar to those of financial options. Both types of options have flexibility because of the option holder has the right to exercise the option but not the obligation. Furthermore, there is an uncertainty in the ideal exercise time point, as the environmental conditions are not predictable. The third property, the irreversibility is mentioned. Exercise of the option incurs costs that can not be compensated.17

Individual parameters of the financial options can be transferred to real options. The base value of a financial option is the present value of future cash flows that result from an investment. These future cash flows, however, are subject to uncertainty, compared They correspond to the volatility of the underlying. The uncertainty comes here from exogenous factors, more information can be collected over the course of time. The exercise price is the present value of the costs caused upon exercise of real options. both the risk-free interest rate that can be set on the basis of return on a government bond serves as a base rate.18 Financial options such as real options also can be distinguished in an American and a European type. The difference is in the time of exercise. An American option can be exercised over the entire term of the option, during the exercise of a European option can only be the end of the option term.19 The term of a real option is how limited the duration of a financial option. However, there is no fixed time, but the term is completed when a competitor exercises the option or market conditions do not permit the exercise.20

Abbildung in dieser Leseprobe nicht enthalten

Table 1: Analogies between financial and real options[21]

The comparability of real and financial options has its limits. There are differences and obstacles which impede the application of option theory to real options.

The base value (underlying) does not exist or is not assessable. The Underlying is not tradable normally, as it is a corporate value. It is therefore illiquid. This has a negative impact on the underlying asset and the value of the real option. Real options have a high uncertainty on account of their complexity. The base price is not exactly taxierbar and the running time is variable and therefore not predictable. In addition, real options are often associated with each other, so that a single observation is difficult.22

A real option is not exclusive as compared to a financial option. A company can have the opportunity to build a factory in a particular location. This possibility also exists for competitors.23 If the option by one of the participating exercised, the value of the option for the other option holders reduced.24

3 Of Real Option

Often the literature refers to the Black and Scholes model as a method to determine the value of real options.25 This is because the model is used in the valuation of financial options and is close because of the analogies transferability. However, the model assumes that the option and the base value (underlying) can be traded. However, since the base value of a real option is a future cash flow, it can not be traded. Furthermore, the premise that it is a European option which can be exercised only at the end of the term applies.26 As discussed in the previous chapter, real options, however, are American options generally and can be exercised any time. Thus, the Black-Scholes model for the valuation of real options is not suitable because real options do not meet the requirements model.

The real options approach is by itself not seen a company valuation model is. Unless you look at a start-up company for which no reliable future CF are estimated. The enterprise value is then calculated by the total value of the existing real options. This process is also called equity approach27, For the company valuation of ROA is only interesting when combined with another method. To this end, has in practice widely used DCF methods. Here (cash flows) are discounted to their present value taking into account the present value calculus future successes. The discount rate is determined using the Capital Asset Pricing Model (CAPM).28 The discounted cash flows are added up and give the passive NPV.29 It is a passive capital value as flexible options for action by management are not included in the corporate environment. To cure this weakness must be identified all existing real options of the company and evaluated. The value of the real options is then added to the determined DCF value and provides the corporate value. This is also referred by the so-called. additive real options approach.30

3.1 Decision tree method

The decision tree method is used for the evaluation of options for action within a company. It presents in a clear manner all possible future environmental conditions. Depending on the environmental situation at a node is decided whether the investment will be pursued or whether a decision is correct and the path we will not be pursued. Here, the difference is the income approach, which start from a static development which can not be changed. To evaluate the expected cash flows are weighted by the probability of occurrence and formed as a result yield values at the individual branches. The evaluation will consist of a roll-back analysis. It is discounted at the risk-adjusted discount rates feet.31

Discounting is one of the biggest criticisms of the decision tree method. Although the process can make a visualization of the options for action, but it is limited to determine the value of the option.32


1 See. Peemöller, V. et al. (2002), S 561st

2 See. Rams, A. (1999), S. 355th

3 See. Adams, M., Rudolf, M. (2009), p.361.

4 See. Krings, U. S. Diehm (2001), p 1135th

5 See. Franke, G., Hax, H. (2004), p.290.

6 See. Myers, SC (1977), p.163.

7 Leithner, S., Liebler, H. (2001), S. 136th

8 See. Beißinger, T. Moeller, J. (1994), p.270.

9 See. Amely, T., Suciu-Sibianu, P. (2001), p 88

10 See. Kuhner, C., Maltry, H. (2006), p.289.

11 See. Adams, M., Rudolf, M. (2009), S.367.

12 See. Leithner, S., Liebler, H. (2001), S. 137 f.

13 See. Leithner, S., Liebler, H. (2001), S. 137 f.

14 See. Peemöller, V., Beckmann, C. (2012), p 1184th

15 See. Leithner, S., Liebler, H. (2001), p.138.

16 See. Hilpisch, Y. (2006), p.66.

17 See. Hommel, U., Pritsch, G. (1999), p.123.

18 See. Meyer, BH (2006), pp 164 et seq.

19 See. Zantow, R. (2004), S. 275th

20 See. Rams, A. (1999), S.353.

21 Own representation. In Anlehung to Copeland, T. / Antikarov, V. (2002) p. 7

22 See. Rams, A. (1999), S.353.

23 See. Copeland, T., Tufano, P. (2004) p. 3

24 See. Leithner, S., Liebler, H. (2001), p.136.

25 See. Kuhner, C., Maltry, H. (2006), p.280 et seq., See. Meyer, BH (2006), p.190 ff.

26 See. Copeland, T., Tufano, P. (2004) p. 3

27 Cf.. Bucher, M. et al. (2002), S. 779th

28 See. Weiser, M. (2003), p.281.

29 See. Weiser, M. (2003), S. 280th

30 See. Rams, A. (1999), p 364., see. Bucher, M. et al. (2002), S. 779th

31 See. Rams, A. (1999), S. 356th

32 See. Peemöller, V., Beckmann, C. (2012), p 1,181th

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Real option approach to business valuation
University of Applied Sciences Essen
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real option, evaluation, dcf, decision tree, corporate
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Patrick Lommertin (Author), 2013, Real option approach to business valuation, Munich, GRIN Verlag,


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