Real growth options
A real option, in simple terms, is the most economically viable option of whether or not to choose any financial investment opportunity. Some of the options include determining whether or not to build a new factory, changing the techniques and technologies of work in the related field, etc.
Types of Real Options
In practise there are a lot of possibilities of real options to occur and some of the major ones are listed as follows:-
Option to expand or contract: After choosing the project it becomes extremely important to decide its size and the scale at which it will be operated based on various calculations and choosing whether to expand the project, contract it, or to just leave it as it is based on various indicators.
Initiation and deferment options: In this category, the management has to decide regarding the timing of the project and has to choose whether to defer or infer the project based on the timings of various market activities and cash flows and working capital available.
Option to abandon: This option relates to abandoning a project if it is no longer viable to operate economically and to realize its salvage value. For example, a factory might need to permanently shut down one of its sectors as it has suddenly become obsolete due to the introduction of new technology.
Option to switch: This option includes shutting down a project in the future when it is not viable and then restarting it when the circumstances are again in the favour of the following project.
Option to prototype: Sometimes bringing a new product can be quite dangerous not only financially but physically as well. These risks could be avoided through prototyping as the product does not need to be manufactured in the full quantity required by the market but just a sufficient quantity needed to do the required tests on the product.
Sequencing option: In case there are two or more projects which needs to be started, this option related to deciding whether or not these projects should be run in parallel to each other (i.e., at the same time) or to run them in a sequence (i.e., one after the other) in which case it also needs to be decided in which order these projects should be run. For example, if there are two projects available and they compliment each other, the most viable option to be to run them in parallel.
Limitations of using the Real options approach
Even though this is a very well thought of framework, it comes with its cons on the following categories of market, organisation and technicalities
The main idea behind the creation of this real options approach was that the market and the business environment should be the ones where change is visibly evident so that all the trends and evolution in the demand and supply point towards volatility of the normal flow of business. If this is not the case then the net present value approach turns out to be more relevant
Using the real options approach requires a lot of flexibility and resources in order to be implemented efficiently and effectively. It requires to fulfill a lot of necessary requirements which the organisation might not be in the position to achieve. Also the management should be in total control of the assets since various options of replacing them might look good on paper but would not be achievable in the practise as sometimes the assets are shared between various parties and the other ones might not be interested in the upgrade as it might not be reasonable to them to do such.
Even after conducting various studies while employing lots of manpower and getting the results of all the options which will help the organisation to grow, they may not be tradeable. For example, the manager of a factory cannot sell the right of sharing the assets by providing them on lease when they are not in use(off season or non working hours), he or she can only agree to it and the actual liquidity of the whole factory depends on various other factors including the market itself. So here it basically comes down to the market liquidity itself.