Are "real options" actually used in the real world?

Block, Stanley
4,325 words
22 September 2007
Engineering Economist
255
ISSN: 0013-791X; Volume 52; Issue 3
English
Copyright 2007 Gale Group Inc. All rights reserved.

The inability of classic NPV analysis to capture the future value of options in a capital budgeting analysis
is now well documented by Trigeorgis (1993, 2005), Copeland and Antikarov (2001), and others. In spite
of this, traditional NPV analysis continues to be described as a normative approach. The author surveys
Fortune 1,000 companies to see if they have picked up on the use of real options to complement
traditional analysis. Out of 279 respondents, 40 were currently using real options (14.3%). While the
percentage is small, the number is higher than in previous studies. The author goes on to describe in
what manner real options are being used and, of equal importance, why they are resisted by many.
Somewhat encouraging is the intent of well over half the nonusers to consider the use of real options in
the future.

INTRODUCTION

In their highly regarded book published at the turn of this century, Copeland and Antikarov (2001)
suggested that real options would dominate the capital budgeting process within the next decade.

As these authors and others, such as Trigeorgis (1993) and van Putten and MacMillan (2004), have
pointed out, the users of net present value and other discounted cash flow methods may not consider
the flexibility to revise decisions after a project has begun. The flexibility might include terminating the
project, taking a more desirable route once initial results are in, greatly expanding the project if there is
unexpected success, and so on. Such elements are particularly likely to be present in natural resource
discovery, technology-related investments, and new product introductions.

But the list does not stop here. Almost every capital budgeting project contains a potential element of
flexibility once it is put into place. There is a real option to change the course of action, and this real
option has a monetary value just as a financial option does.

While many proponents of real options are critical of NPV analysis, it is not necessarily NPV analysis
that is at fault per se, but rather the improper use of it in many cases. One can use NPV analysis
"correctly" if all options (invest, do not invest, delay, etc.) are known at the start of the project such that
they all can be evaluated. This is why decision trees were developed. The benefit of real options
analysis is that it incorporates volatility, whereas decision trees (which rely on NPV analysis) only
compute expected values.

CAPITAL BUDGETING STUDIES AND REAL OPTIONS

Capital budgeting techniques used in business have been studied extensively by Mao (1970), Gitman
and Forrester (1977), Schall, Sundem, and Geigsbeck (1978), Scott and Petty (1984), Canada and
Miller (1984), Block (2005), and others. The central message throughout is that major industrial firms are
moving toward the normative in various areas of capital budgeting.

However, the topic of real options is not covered or scores poorly in terms of utilization. For example, as
reported by Teach (2003), in 2000, Bain and Company conducted a survey of 451 senior executives
covering 30 industries regarding their views of management techniques, and only 9% reported using
real options. Also, Ryan and Ryan's (2002) survey of 208 CFOs found real options trailing the list of 13
supplementary capital budgeting techniques with a utilization rate of 11.4%. In contrast, 85.1% of the
respondents used sensitivity analysis and 96% used traditional net present value analysis for basic
capital budgeting. In both of these studies, the inclusion of real options was an afterthought with no
follow-up questions or analysis.

The current article is specifically dedicated to real options with the intent of finding out who is doing what
and why.

It is organized as follows. In the following section, the methodology behind the current study is
described; then the presently existing practices using real options are covered, the resistance to real
options is analyzed, and a summary and conclusion follow, along with the future outlook.

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METHODOLOGY UTILIZED IN THE CURRENT STUDY

The author used the Fortune 1,000 companies as the initial database for the study. Two hundred and
seventy-nine usable responses were returned by the top-ranking financial officer of the firm or his
designate. The three-page questionnaire was based on a pilot study of 50 Fortune 1,000 companies to
ensure clarity of meaning.

A follow-up telephone survey of 40 randomly selected non-respondents subsequent to the actual

mail-out indicated no statistically significant difference between those who initially answered the
questionnaire and those who elected not to participate.

The financial characteristics of the participating firms are presented in Table 1. Of equal importance is
the industry of origin of the survey participants. The industry listings of those firms who participated in
the survey are presented in Table 2. The 12 categories are the most representative of the two-digit SIC
codes of the respondents. Not all categories are mutually exclusive, so the emphasis is on the firm's
primary area of activity. The fraction of responding firms versus non-responding firms, broken down by
two-digit SIC codes, was generally consistent across all categories.

PRESENTLY EXISTING PRACTICES

The question of primary interest is what percentage of the respondents use real options as part of their
capital budgeting process. Forty respondents, representing 14.3% of the survey participants, indicated
the use of real options. Out of the 40 users, 18 indicated major utilization, 13 indicated they used real
options as a supplemental tool, and 9 reported using real options to shadow the results of more
commonly used methods.

In terms of the applications of real options to different types of decisions by the 40 users, the answers
are reported in Table 3.

While the categories are clearly not mutually exclusive, and many respondents indicated an overlap, it is
apparent that the nature of the decisions indicated has a high degree of uncertainty. Clearly, a new
product introduction has subsequent components in which a decision must be made to either add
additional resources, penetrate different markets, cut back on expenditures, or even abandon the
project. The same type of decisions relate to research and development, mergers and acquisitions, and
other categories.

INDUSTRY OF USERS

In their work, Triantis and Borison (2001) found that there were tendencies among those who employ
real options to represent certain industries. Out of the 40 users in this study, 37 came from the following:
technology (13), energy (11), utilities (6), health care (4), and manufacturing (3). Interestingly enough,
finance had only two users and transportation had one. More will be said about the low participation rate
by the financial sector (investment banking, commercial banking, etc.) later in the article.

A chi-square independence of classification test indicated that a null hypothesis that there was no
relationship between industry classification and use of real options could be rejected at an alpha level of
.01. The results are unknown in the appendix.

METHODS OF UTILIZATION

For the 40 firms that utilize real options, a follow-up question pertained to what technique they used in
their implementation. They were given four major categories as well as another category. The major
choices were those previously cited by Triantis and Borison (2001) in their research. The responses are
shown in Table 4.

Needless to say, the approaches are not mutually exclusive and many were used in combination. The
emphasis here is on the primary method of utilization. Also, some respondents used slightly different
names for one of the four approaches listed here, but the intent was the same and was categorized as
such.

While the binomial approach is the most frequently used, it was thought by the respondents to be more
simplistic than the risk-adjusted decision tree approach or Monte Carlo simulation.

Although the Black-Scholes option pricing model is the key to valuation for financial options, the same
cannot be said for real options. The Black-Scholes model requires knowledge of five variables: the price
of the underlying asset, the price at which the option can be exercised profitably, the amount of time
before the expiration date, the risk-free rate of interest, and the volatility of the underlying asset. Many of
these variables are simply unavailable for real option analysis. For example, the time period before
expiration can be easily determined for a financial option but is not discernable for a real option, where
flexible decision-making allows for many different potential exercise dates, depending on how the
project is progressing.

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To determine if there were industry preferences among the four different methods of utilizing real
options, a chi-square test was once again run in which the null hypothesis was that there is no
relationship to the technique used with real options and industry classification. The null hypothesis could
be accepted at almost any reasonable level of significance. There is no discernable relationship
between technique used and industry classification. The results are shown in part b of the appendix.

In their research, van Putten and MacMillan (2004), Trigeorgis (2005), and others have stressed the
importance of treating real options as a component of expanded net present value rather than as a
stand-alone approach. The NPV is determined and the value of the real option is added.

Total value = passive NPV + real option value + other adjustments

Thus, it is possible to have a project that has a negative net present value but a positive total project
value because of the presence of the real option. By failing to account for the real option value, an
incorrect decision may be made. This is particularly likely to happen in projects in which there is a high
degree of risk but also a large amount of flexibility. The classic NPV approach, if not properly used, may
fail to pick up the value of being able to change the plan in the early, middle, or late stages of the
project. The classic NPV is likely to have the greatest value in the early years of the project because of
the time value of money, whereas the real option component may be more valuable in the later life of
the project because uncertainty may be at its highest level and flexibility at its most valuable point.

Thus, classic, stand-alone NPV, if not properly used, may undervalue potential rewards in the research
for new drugs in the pharmaceutical industry, the exploration for natural resources in the energy
industry, and so on. Eighty two percent of the respondents employing real options indicated that they
use the valuation of real options as a component (add-on) to the classic NPV approach rather than as a
stand-alone item. The classic NPV is retained but modified to reflect how managers think and act in the
real world.

Of further interest is the fact that 32% of the respondents indicated that the decision to reject was
reversed after the introduction of real options into the analysis.

NONUSERS OF REAL OPTIONS

Two hundred and thirty-nine out of the 279 respondents indicated they did not use real options. When
asked for the reasons why, the answers in Table 5 were provided.

The number one reason for not using real options is the lack of top management support. While that can
take on many different meanings, further comments indicated that the top managers of many companies
are hesitant to accept a methodology they cannot follow step by step. Many felt that top management
was turning decision-making over to mathematicians and decision scientists, and they were being taken
out of the loop.

While van Putten and MacMillan (2004) emphasized that real option decisions could be simplified to a
go, no-go approach to an investment, a number of respondents thought that was being patronizing to
top management and reduced top management's perceived power as sophisticated decision-makers.

The second reason given for not using real options is that discounted cash flow is a proven method and
therefore a preferred method. One can hardly blame the respondents for taking an approach that is
heavily favored in the literature. The typical procedure in texts and corporate manuals is to downplay
methods such as the payback period and the average rate of return and highlight the superiority of NPV
and IRR, which are based on the time value of money and the use of cash flow rather than GAAP
earnings. Real option--based books such as Copeland and Antikarov (2001), Amran and Kulatilaka
(1998), and Trigeorgis (1996) drew little attention from the nonusers. Many thought they were already
using the normative approach.

The third major reason for nonutilization of the real options is that the real options required a high
degree of sophistication. Earlier in the article it was suggested that the greatest utilization of real options
was in technology, energy, utilities, etc., and that is consistent with the fact that top management in
those industries often have engineering or technology backgrounds. Other industries such as retailing,
food processing, and publishing had virtually no utilization of real options.

Not only is top management more mathematically sophisticated in certain industries, but lower level
management, which does the initial analysis, may also be more mathematically sophisticated. An
accounting major or even an MBA may be less likely to engage in mathematically dependent real
option analysis than an engineer or scientist.

One respondent said, "Those with a background in the sciences and engineering love the challenges of
dealing with real options. They want to map the decision process and use their mathematical skills to
address the issues."

In order to isolate on the people making decisions, the author inquired about the background of the
people generally thought to be in control. Distinctions were made between scientific and financial

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backgrounds, and a null hypothesis that there is no relationship between the training of decision-makers
and the use of real options was tested. The stated hypothesis could be rejected at an alpha level of .05
as indicated in part c of the appendix.

The fourth reason given for the nonuse of real options is that they tend to encourage excessive
risk-taking. As stated by van Putten and MacMillan (2004) based on their conversations with top
executives:

For all their theoretical attractiveness as a way to value growth

projects, real options have had a difficult time catching on with
managers. CFOs tell us that real options overestimate the value of
uncertain projects, encouraging companies to over-invest in them.
In the worst case, they grant excessively ambitious managers a
license to gamble with shareholder's money.

Thus, while real options were initially introduced to make companies more
competitive by taking on projects that were difficult to evaluate because of
uncertainty, they have taken on a different reputation in the eyes of some
executives. This is not a point to be taken lightly and requires that
academics study the practitioner's concerns in a rigorous manner in future
studies of real options. Some of the resistance could be associated with
academia's lack of understanding of the incentive effects of real options on
institutional decisions.

Many respondents indicated that whether the methodology is correct or not,

there is no assurance that operating managers will actually follow the
decision-making options covered in the initial analysis. While there may be
a chance for abandonment in a latter stage of the project, thus recovering
part of the initial investment (under the use of real options or NPV
analysis), managers at that point in time may have a vested interest in
having the project continue because they have been identified with it.
Discontinuation may even mean recognition of poor earlier judgment and loss
of employment. One might suggest that until the corporate culture is changed
so that closing down existing operations is rewarded instead of punished,
the implementation of the assumptions that are part of the real options
process may not happen.

Both proponents of real options and those who resist them may suggest that
they are keeping their eye on the ultimate goal of stockholder wealth
maximization. Although Triantis and Borison (2001) maintain that this is one
of the strongest arguments for the use of real options, a chi-square
independence of classification test indicated there is no relationship
between the use or nonuse of real options and the desire to maximize
stockholder wealth as indicated in part d of the appendix.

Interestingly enough, those in the financial community where the goal of

stockholder wealth maximization is most widely touted showed little or no
interest in real options. It would appear that until the value of real
options is included into the valuation models used on Wall Street and
elsewhere, there may be little movement in this area of finance.

However, the future for real options in the overall economy is not
necessarily discouraging. As previously stated, 40 of the 279 respondents to
this study (14.3%) are currently using real options. Of the 239 nonusers,
43.5% indicate that there is a good chance they will seriously consider
using real options in the future, 15.9% indicate that there is some chance,
and only 26.3% totally reject the potential of using real options.

SUMMARY AND CONCLUSION

The inability of classic NPV analysis to capture the future options in a

capital budgeting decision is now well documented by Trigeorgis (1993),
Copeland and Antikarov (2001), and others. The misuse of classic net present
value analysis may understate the value of a potential investment and lead
to an incorrect decision, particularly when a high degree of uncertainty is
involved. Instead of rewarding the asymmetric nature of returns under
uncertainty in which future action can allow positive results, classic NPV
may penalize future uncertainty through the risk-adjusted discount rate.

In spite of the points made above, the use of real options by U.S. companies
is limited. From a mailing to the Fortune 1,000 largest companies, 279
usable responses were returned. Forty respondents (14.3%) currently used

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real options in the capital budgeting process. However, the percentage is
somewhat higher than that in prior studies and useful observations can be
drawn from the 40 users and 239 nonusers.

The users come primarily from industries where sophisticated analysis is the
norm, such as technology (13), energy (11), utilities (6), and other similar
segments of the economy. Respondents were divided into 12 major industrial
classifications and a null hypothesis that there is no relationship between
industrial classification and the use of real options could be rejected at
an alpha level of .01 using a chi-square test.

The Black-Scholes option pricing model was rejected by almost all the users
in preference to such approaches as binomial lattices, decision trees, Monte
Carlo simulation, and so on.

The nonusers of real options provide interesting information as well. In a

time period in which the normative approach to the capital budgeting
decision is stressed as a key ingredient to stockholder wealth maximization,
85.7% of the respondents are not using a valuable tool in the form of real
options.

The primary reasons given for nonuse of real options in order of importance
are (a) lack of top management support; (b) discounted cash flow is already
a proven method; (c) real options require too much sophistication; and (d)
real options encourage excessive risk-taking.

On a more positive note, 43.5% of the nonusers said that there is a good
chance they will consider the use of real options in the future, 15.9%
indicate a positive but less committed response, and only 26.3% totally
reject the use of real options in the future.

APPENDIX

Chi-Square Independence of Classification Tests

Alpha

[chi
Null hypothesis square] D.F. .01 .05 .10

a. Use of real options is 27.627 11 24.725 19.675 17.275

independent of
industry classification

b. The techniques used 18.268 19 36.191 30.44 27.204

for real options is
independent of
industry classification

c. Use of real options is 32.197 19 36.191 30.144 27.204

independent of the
training of
decision-makers

d. The goal of 4.173 3 11.345 7.815 6.251

stockholder wealth
maximization is
independent of the
use of real options

Null hypothesis Conclusion

a. Use of real options is Reject the hypothesis at

independent of at .01 level of
industry classification significance. Industry
classification has a
significant
relationship to the use
of real options

b. The techniques used Accept the hypothesis.

for real options is Industry classification
independent of does not have a
industry classification significant

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 relationship to
technique used

c. Use of real options is Reject the hypothesis at

independent of the a .05 level of
training of significance. Training
decision-makers of decision-makers
has a significant
relationship to the use
of real options

d. The goal of Accept the hypothesis.

stockholder wealth The use of real
maximization is options does not have
independent of the a significant
use of real options relationship to the
goal of stockholder
wealth maximization

REFERENCES

Amram, M. and Kulatilaka, N. (1998) Real options: Managing strategic

investments in an uncertain world. Cambridge, MA: HBS Press.

Block, S. (2005) Are there differences in capital budgeting procedures

between industries? An empirical study. The Engineering Economist, 50(1),
55-67.

Canada, J.R. and Miller, N.P. (1984) Review of surveys on capital budgeting
evaluation techniques. The Engineering Economist, 30(2), 193-200.

Copeland, T. and Antikarov, V. (2001) Real options: A practitioner's guide,

New York: TEXERE LLC.

Gitman, L.J. and Forrester, J.R., Jr. (1977) A survey of capital budgeting
techniques used by major U.S. firms. Financial Management, 6(3), 66-71.

Mao, J.C. (1970) Survey of capital budgeting: Theory and practice. Journal
of Finance, 25(2), 349-360.

Ryan, P.A. and Ryan, G.P. (2002) Capital budgeting practice of the Fortune
1,000: How have things changed. Journal of Business and Management, 8(4),
355-364.

Schall, L.D., Sundem, G.L., and Geigsbeek, W.R. (1978) Survey and analysis
of capital budgeting methods. Journal of Finance, 33(1), 281-287.

Scott, D.F., Jr. and Petty, J.W. (1984) Capital budgeting practices in large
American firms: A retrospective analysis in synthesis. Financial Review,
19(1), 111-123.

Teach, E. (2003) Will real options take root? Available at:

http://www.CFO.com (accessed)

Triantis, A. and Borison, A. (2001) Real options: State of practice. Journal

of Applied Corporate Finance, 14(2), 8-24.

Trigeorgis, L. (1993) Topics in real options and applications. Financial

Management, 22(3), 202-223.

Trigeorgis, L. (1996) Real Options; Managerial Flexibility and Strategy in

Resource Allocations. Cambridge, MA: MIT Press.

Trigeorgis, L. (2005) Making use of real options simple: An overview and

applications in flexible/modular decision making. The Engineering Eeonomist,
50(1), 25-53.

van Putten, A.B. and MacMillan, I.C. (2004) Making real options really work.
Harvard Business Review, 82(12), 134.

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Address correspondence to Stanley Block, M.J. Neeley School of Business,
P.O. Box 298530, Texas Christian University, Fort Worth, TX 76129. E-mail:
sblock@tcu.edu

Stanley Block

M. J. Neeley School of Business, Texas Christian University, Fort Worth,

Texas, USA

BIOGRAPHICAL SKETCHES

STANLEY BLOCK, Ph.D., C.EA., is professor of finance and holder of the

Stanley Block Endowed Chair of Finance at Texas Christian University, Fort
Worth. He is the coauthor with Geoffrey Hirt of numerous books in finance
including Foundations in Financial Management and Fundamental of Investment
Management. The first text has sold over a million copies. He has published
approximately 50 articles in such journals as Financial Management, The
Journal of Financial Services Research, Journal of Portfolio Management, The
Journal of Accountancy, The Financial Analysts Journal, The Engineering
Economist, and the Journal of Finance. He is past president of the
Southwestern Finance Association and a former director of the Financial
Management Association. He serves as consultant to a number of companies
throughout the world and has held board of director positions with three
publicly traded companies. At TCU he has twice won the award as the
outstanding instructor in the MBA program.

Table 1a. Characteristics of survey participants:

total revenue of survey participants

Number

Under $2 billion 62
$2 billion to $4 billions 70
$4 billion to $6 billion 38
$6 billion to $8 billion 28
$8 billion to $10 billion 14
$10 billion to $15 billion 23
$15 billion to $20 billion 11
$20 billion to $30 billion 13
Over $30 billion 20
279

Table 1b. Characteristics of survey participants:

net profit (loss) of survey participants

Number

Loss 29
0-$200 million 32
$200-$400 million 40
$400-$600 million 44
$600-$800 million 36
$800 million-$1 billion 22
$1 billion-1.5 billion 38
$1.5 billion-$2 billion 10
Over $2 billion 28
279

Table 1c. Characteristics of survey

participants: ratio of research and
development to total revenue of survey
participants (2005)

Number

0-1% 14
1-2% 31
2-3% 67
3-4% 79
4-5% 63
5-6% 17
6-7% 5
7-8% 2
Over 8% 1

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 279

Table 2. Primary industry of survey participants (2005)

Number

Beverages 3
Energy 25
Finance 31
Food processing 9
Health care 26
Manufacturing 57
Publishing 5
Retail 44
Technology 36
Transportation 12
Wholesale 9
Utilities 22
279

Table 3. Types of applications of real options

New product introduction 36.2%

Research and development 27.8
Mergers or acquisitions 22.1
Foreign investment 9.6
Other 4.3
100.0
Table 4. Techniques for using real options

Binomial lattices 16
Risk-adjusted decision trees 12
Monte Carlo simulation 9
Black-Scholes option pricing model 1
Other 2
40

Table 5. Reasons for not using real options

Lack of top management support 42.7%

Discounted cash flow is a proven method 25.6
Requires too much sophistication 19.5
Encourages too much risk taking 12.2
100%

COPYRIGHT 2007 Institute of Industrial Engineers, Inc. (IIE)

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