Real Options: Does Theory Meet Practice? Professor Alexander J. Triantis

Evolution of RO: Theory and Practice Theory –Over 750 papers during the last 20 years –Accelerating research productivity –Interdisciplinary research area Practice –Took off in the mid-1990s –RO usage at around 10%? –High attrition rate?

New Insights and a New Vocabulary Key insights: –Reactive and proactive management –Redesigning processes –Transacting in flexibility –Risk-return issue is complex Management –Transformational insights –Insights confirmed, and new vocabulary

Killer Aps Natural Resources, R&D, Manufacturing, M&A, and Infrastructure Some common characteristics –Large investments, low/no up-front cash flow –High uncertainty, but available data –Structured series of stages –Engineers and scientists

Real Options in the Crosshairs The internet bubble and Enron “Old Wine, New Bottles” Need to model reality, not perfection The “extreme sport” view of real options RO

Agenda for Research Perfecting the models of perfection Splitting options Modeling managerial behavior Developing heuristics Valuing and managing the firm

Perfecting the Models of Perfection Modeling and Estimating Distributions –mean-reversion, jumps, stochastic parameters Pricing risk –commodity-based applications –underlying project comparables Powerful Computational Techniques

Splitting options Most real options not held exclusively or completely by a single company Split across competitors –wide range of assumptions and models Split along value chain –contract design to get to first-best solution

Modeling Managerial Behavior Tools don’t make decisions, people do! Two key issues –Cognitive biases –Managerial incentives Estimate sub-optimal behavior Alter the behavior –Good luck vs. good decisions? RO Twist: Flexibility can be misused

Developing Heuristics Accuracy vs. Simplicity –Simpler models are more likely to be used –Complex models can be used as benchmarks Heuristics –NPV w. WACC; higher hurdle rate –Enables the technology transfer Software - framing, computations, graphs

Valuing and managing the firm Managers respond to analysts’ metrics All the other four pieces need to be in place +Modeling project interactions +Effects of capital structure and risk management Goals Internal management and valuation External valuation

Going Forward Adoption of real options –organizational factors –quality and simplicity of tool Real options  Capital budgeting –NPV special case –no longer a “supplementary” tool Responding to critiques essential to bridging gap between theory and practice