Carnegie Mellon University

Real Options

Course Number: 45964

Description: Managers need advice on what actions to take or how to value a firm managed by others.

This advice is particularly relevant when it pertains to strategic and tactical decisions. Before we can advise managers on what to do, we need to specify an objective function to be optimized. This task is nontrivial, because there is potential for disagreement among shareholders, due to differences in their risk attitudes, time preferences, wealth, and labor income. However, if we consider (i) sufficiently small projects that do not affect market prices (price taking assumption) and (ii) that generate cash flows that can be replicated using portfolios of traded securities (partial spanning assumption), then shareholders all agree that managers should maximize the market value of a firm's equity. Even when these assumptions are violated, this objective function can be a reasonable proxy for guiding managerial decision making. The standard net present value rule used by static discounted cash flow analysis is consistent with this objective function only in very special circumstances: The selection of now or never projects characterized by a deterministic stream of future cash flows. That is, this approach ignores the ability of managers to use all the available information when deciding on the timing to undertake a project and when managing a project.

In contrast to static discounted cash flow analysis, real options analysis is an approach to managerial decision making that always assumes that managers maximize the market value of projects and they use all the available information when making decisions, in particular when managing projects that involve dynamic and state contingent choices among alternatives (options), such as, expanding/reducing manufacturing capacity, investing in new products or technology, suspending production, and mothballing a plant. The resulting valuation and managerial decisions can thus be very different when real options analysis is used rather than static discounted cash flow analysis.

The partial spanning and price taking assumptions of the real options approach are also the basis of the Black‐Scholes‐Merton approach to the valuation of financial options. The real options approach thus extends this fundamental market driven valuation approach to a much broader spectrum of managerial decision making concerns.

The course provides the student with a set of essential tools for applying real options analysis. In particular, the course

  • Presents the key components of a real options model: Exogenous state variables whose values evolve independently of the manager's actions, the process that governs the future behavior of the values of these state variables, the actions that a manager can take, the endogenous state variables whose values evolve according to these actions, and the cash flows that depend on the current state variable values and the current manager's actions.
  • Introduces dynamic programming (backward recursion combined with decision making) applied to (binomial) tree representations of the evolution of the exogenous state variables as a general technique to solve a real options problem; that is, to obtain optimal dynamic decision policies rather than static decision policies.
  • Uses various applications to illustrate the use of these tools in practice.

The course focuses on energy and commodity applications, because the real options approach is the common language among managers in these industries, given that energy and commodity derivatives are traded on exchanges such as CME, NYMEX, and ICE. Other applications include, but are not limited to, the manufacturing, pharmaceutical, and real estate industries, and research and development projects. The course thus includes essential content for prospective managers and consultants in energy and high technology industries.

Overall, the emphasis of the course is on developing the student ability to take an unstructured problem and implement real options analysis in a structured manner.  Assessment activities: Homework assignments, cases (if I can find interesting ones), and a final or, alternatively, a course project/paper.

Textbook: Graeme Guthrie, Real Options in Theory and Practice, Oxford University Press, New York,
2009, ISBN: 9780195380637.

Degree: MBA
Concentration: Operations Management
Academic Year: 2022-2023
Semester(s): Mini 1
Required/Elective: Elective
Units: 6


Lecture: 100min/wk and Recitation: 50min/wk