A real option is a decision or choice to invest a little or a lot in a product, a technology, or a project. They are called real options because they are investments in tangible assets, products, processes, and services rather than financial instruments such as stocks. For financial investments, option-pricing techniques are heavily used to take into account the flexibility issue. The most popular is the Black–Scholes option-pricing model where the option value is determined by five input values of the exercise price of an option, the time to exercise date, the current price of the asset, the variance per period of rate of return on asset, and the risk-free rate of interest. If you plug all these values into the Black–Scholes option-pricing model, you would get a positive value (do not forget all options have a positive value). This is the option value. This value would be added to the NPV analysis. So, what is initially a negative NPV would become a positive NPV once the project’s option value is incorporated. This calculation looks very simple. However, investments in technology differ from those in financial assets in terms of priceability and tradability of the underlying asset. Contrary to financial investments, in technology investment situations, the price of an underlying asset is hard to know, and the underlying asset cannot be traded easily.
The purpose of a real option is to explore the potential of a product or new technology. Car manufacturers are constantly making small investments (from their perspective) in emerging technologies. They purchase real options in fuel technologies, engine technologies, drive-by-wire technologies, steering and braking technologies, advanced construction materials, and design. Sometimes they invest a little money and just search for information and try to understand whether a technology is applicable and cost-effective. Sometimes they invest a lot of money and develop full-blown prototypes using a variety of technologies and showcase the technologies in the so-called concept cars. Sometimes they decide to go whole-hog and develop a fresh line with modern features and technologies. Sometimes they just abandon a product or a technology completely.
Amazon did not just settle into the production of the Kindle e-book. They explored various technologies such as the screen technologies, the book delivery mechanism, and the file format for storing the books as well as if consumers would be interested in reading e-books.
The following example illustrates how a real options analysis can be conducted.
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