Level 1 CFA® Exam:
Real Options & Capital Allocation Mistakes

Decision-makers have noticed that in practice the approaches to the evaluation of an investment project we've discussed so far are rather rigid. Why is it so? The methods we've presented (both NPV and IRR) assume a certain investment outlay that doesn't change and they consider particular estimates of cash flows generated by a project.

However, in reality, the investment can be complicated and the final effect depends on a series of various decisions. If so, we deal with the so-called real option which is the right to change a decision on a particular project based on new information. Real options are very similar to financial options. In both cases, a holder has a right, not an obligation, to use an option. So, a company holding a real option exercises it at the most favorable moment. The value of the option increases together with the incurred risk.

Now it's time to discuss the methods of real options analysis. We distinguish among 4 approaches to evaluating real options:

1. The first method assumes employing discounted cash flow models like NPV. Under this approach, we evaluate the project as if there were no options. If the NPV is positive without considering the options, there's no point in carrying on the analysis. This is because even though we don't know an approximate value of the real option, we can assume it will add value to the project.
2. In the second approach we're trying to determine the value of an option. We can do it using the following relation: Project NPV Including Option Value = Project NPV – Cost of Options + Value of Options. It may happen that the project NPV calculated without taking into account a real option will be negative. However, if we add the option and deduct its costs, the project may have a positive NPV and can be carried out.
3. In the third approach we use decision trees. Such decision trees make it easier for us to organize and track sequences of decisions made at particular moments and their influence on the final effect of the investment.
4. The fourth and last approach uses option pricing models. Such analysis is the most challenging and it is often employed by professionals who specialize in quantitative methods and derivatives.

To get to the core of the concept of real options let's solve a problem.

1. A real option is the right to change a decision on a particular project based on new information.
2. Basic types of real options are: timing options, sizing options, flexibility options, and fundamental options.
3. Timing options allow for delaying the project.
4. Sizing options allow for changing the size of the business activity.
5. When demand exceeds supply, a company may increase its sales simply by increasing the prices without any change in production (a price-setting option).
6. A production-flexibility option is exercised when a company for example changes its production volume, materials, or suppliers.
7. In fundamental options the risk is that the whole investment could fail.
8. We distinguish among 4 approaches to evaluating real options: using discounted cash flow models like NPV without taking into account the value of options, determining the value of an option and including it together with option costs in the NPV valuation, using decision trees, and using option pricing models.
9. Capital allocation mistakes: forgetting about the economic responses of the competition, template errors, pet projects, focusing on EPS, ROE, or net profit, relying on IRR too frequently, bad accounting of cash flows, bad estimation of overhead costs, discount rate errors, overspend or underspend the capital needed, overlooking the right projects in the idea generation step, and including sunk costs in investment analysis.