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Use of Real Options Theory in Financial Management/Modeling - Term Paper Example

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Use of Real Options Theory in Financial Management/Modeling

In every business, the need to estimate the future cashflow is very important. Businesses have to evaluate the cost of capital and also estimate the future returns that will accrue to the capital when it is invested. In so doing, there is the need for certain forecasting activities to be undertaken to ascertain the future worth of projects and the returns they would yield. From my previous knowledge in finance and economics, I thought the best methods of forecasting and analyzing the cost of capital were the traditional methods like Net Present Value, Internal Rate of Return amongst others.
However, at the earliest stages of studying the Real Options Theory, I realized that those systems are too technical in nature. In other words, they are too specialized and do not take cognizance of important elements of businesses. In my observation of the business environment, I notice that ten years ago, most businesses had finance departments that were often very distinct from the rest of the business. The finance departments specialized in the use of techniques like NPV and the like to forecast and submit reports to the people charged with the management of the business. ...
It is common knowledge for people to discount projects and get very good results that indicate that the project is viable. However, in reality, when the project starts, the contractors come back and request for more money. This particular trend is so common that most projects are defined by that kind of trend. This suggests to me that the traditional discounting and forecasting tools and techniques of finance do not take into consideration, important elements of the business environment before they are invoked. In other words, most techniques of finance are limited in scope and due to this, they do not cover strategic issues appreciably and end up being weak tools and techniques for planning in businesses. Also, it is worthy to note that most financial professionals use these tools and techniques based on very specialized technical details. These jargons and assumptions are likely to make a manager with little exposure to finance bored and this can defeat the purpose for which such tools and techniques are used - that is the need to use the reports of such projects for decision making that would bring positive results to the business as a whole. Due to these weaknesses in forecasting tools and techniques, there is the need for some kind of finance technique that will enable managers and top-level decision making groups to take the best decision that brings the optimum results to the organization as a whole. The Real Options Theory I learnt from the course that the Real Options Theory uses decision analysis and other techniques of the valuation option put forward by Black & Scholes to analyze the entire environments before a group of managers can take a decision on a given financial ...Show more
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This paper is a reflective account of my participation of the finance course of my program.It identifies the reasons why this theory is relevant to management in today's world and goes on to describe the new things I learnt in this course…
Use of Real Options Theory in Financial Management/Modeling
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