Thus, real options are much flexible since they offer a broader view. Real options make it possible to contract, expand, defer or abandon an investment as opposed to DCF model commonly known as net present value rule (NPV) which does not consider the element of uncertainty. The real option theory is as valid as it can be since it heavily relies on with common day to day data obtained from financial markets. Real options complement discounted cash flow by availing an element of analytical flexibility that makes it possible to combine strategic intuition and analytical rigor. Contrary to real options, financial options give the right and not the obligation to its owner to buy or sell a security at a stated price. Examples of such investments include licensing agreements, new plants, joint venture and line extensions (Luehrman, 2011). Real options give a company the right but not the obligation to create an investment whose value is likely to increase. Real options being an extension of financial option theory brings into consideration things such as options that are not related to finance in any way or options that are real. Real Options versus Discounted Cash Flow Model By juxtaposing real options to the traditional valuation model, an investor can fully appreciate the power of this analytical tool. Businesses that enjoy economies of scale are highly likely to benefit from real options since they have access to richest opportunities and best information (Karami and Farsani, 2011). This is so because such managers will be capable of identifying, understanding and creating real options and eventually put such knowledge into practice. Businesses with adequate capital, reputable and intelligent management are more likely to fare well with real options. Economic changes occurring from time to time are a fertile breeding ground for real options. Managers who are keen on maintaining the status quo will certainly miss the opportunities availed by this analytical tool. Real options are viable where particular conditions are met. This need if fulfilled by real options which gives them requisite insights into strategic investments and businesses. There is need for managers and investors to understand how to take advantage of rapid changes that are occurring in economic world. The Black-Scholes model is one of the best known forms of financial option theory that is applied through real options. Real options refer to a relatively new financial analytical tool that helps investors and managers to select market valuations that reflect a blend of businesses that are already known together with the value of business opportunities that are likely to arise. However, it would be prudent to understand what conditions make them to be valuable. Real options dominate every aspect of decisions made by business managers. Other strategic options open for consideration by an acquiring firm are often ignored during valuation. Moreover, it fails to measure the option to control and liquidate a company owned by shareholders. Also, discounted cash flow valuation model does not consider other options that a company may own such as rights to natural reserves, patents and licenses. An example of such problems is where a project’s net present value fails to capture the values of the options to expand, delay or even abandon an ongoing project (Baker etal, 2011). To allay the shortcomings of traditional cash flow model, real options theory is used instead. Though many actions have real options entrenched in them, there are conditions that must be met for real options to be valuable. Real options when considered can help in adding value to most acquisitions and investments that would otherwise be invalid. According to the experts mainly academics and practitioners, the options need to be valued and considered explicitly since their value can be significant. Of late, experts have expressed concerns over alleged inefficiency of traditional cash flow models such as discounted cash flow model in capturing the value of the options entrenched in most actions of the corporate.
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