Options And Capital Budgeting

Most of the options we have discussed so far are financial options because they involve the right to buy or sell financial assets such as shares of stock. In contrast, real options involve real assets. As we will discuss in this section, our understanding of capital budgeting can be greatly enhanced by recognizing that many corporate investment decisions really amount to the evaluation of real options.

To give a simple example of a real option, imagine that you are shopping for a used car. You find one that you like for $4,000, but you are not completely sure. So, you give the owner of the car $150 to hold the car for you for one week, meaning that you have one week to buy the car or else you forfeit your $150. As you probably recognize, what you have done here is to purchase a call option, giving you the right to buy the car at a fixed price for a fixed time. It's a real option because the underlying asset (the car) is a real asset.

The use of options such as the one in our car example is very common in the business world. For example, real estate developers frequently need to purchase several smaller tracts of land from different owners to assemble a single larger tract. The development can't go forward unless all of the smaller properties are obtained. In this case, the developer will often buy options on the individual properties, but only exercise those options if all of the necessary pieces can be obtained.

These examples involve explicit options. As it turns out, almost all capital budgeting decisions contain numerous implicit options. We discuss the most important types of these next.

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