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Use of Theory of Real Option

Autor:   •  September 16, 2012  •  Research Paper  •  3,286 Words (14 Pages)  •  881 Views

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My paper will analyze how real options theory can be effectively used in the area of financial management. Real options theory makes it possible for managers to better analyze different opportunities with several options available. These opportunities have varying risk factors and being flexible is a more useful resource for investments. I will also explain new items in the real options theory along with my own experiences as a business owner. My personal experiences in different aspects of life has helped me to understand this theory although I may not have known about it while I was living it.

The Real Options Theory is not a new concept but has gained interest. According to Financial Modeling Guide, Real options or strategic options, are opportunities that are embedded in projects or investments that are available and could have a real economic impact on cash flow and risk. The real options that are embedded in a project will impact the project’s strategic net present value or NPV. This value differs from the traditional NPV as follow: Traditional NPV + Value of real options = Strategic NPV (Financial Modeling Guide, 2011).

In my career that has included a few jobs, had retirement investment options available. These investments were ranked by what risk was involved and what the potential earnings could be. As an example I worked at General Motors for around 15 years. When I first started with the company we only had our original retirement package. When I was at General Motors for about 5 years, they came to use with an investment company called Fidelity Investments. These investments were going to be managed by us with the aid of an investment broker. The broker’s job was to inform us on these investments weighing the risks and possible rewards. My broker asked what my priorities were for an investment. I was under 30 so I felt risk was worth the possible reward. The broker proceeded to tell me about a balanced portfolio that offered stability over a higher potential payoff. I decided to follow his advice and built up a nice portfolio.

After doing this balanced portfolio for a few years I decided to go for the higher reward investment that I had been investing into for a few years. This investment had constantly paid off in double digits so I felt I would drop the low risk investments that only paid barely single digit returns. The gamble worked well up until 2006 right before the bubble started to burst at General Motors. In the month of January I was laid off for the first time in over 10 years. I thought about taking out my 401k but decided to let it ride. I had made thousands of dollars in returns over the years and felt it was safe. In April 2006 I was told I was no longer safe at General Motors and that they were downsizing. I was told that I was going to be let go but I could either take a buyout or I would be laid off indefinitely since there was nowhere to transfer to. My department was


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