Real Option Valuation: An Introduction

This chapter explores the definition of real options, the applications of real option analysis to mergers and acquisitions (M&A), the interpretation of the real option result and what it really means, and the methodology of how to perform real option valuation in an M&A setting. The value of a real option is the value today of the flexibility of having the right to make or sell or delay the future investment, just before the real investment opportunity is no longer available or determined to be viable. Real options have value under conditions where an investment, if made, is irreversible. They are made in a world where potential returns and their timing are uncertain and very volatile. The greater the length of time required between today and the future exercise date, the greater is the option value resulting from having more time to evaluate the opportunity.