Mckinsey RD Case Essay

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CHARLENE POTTS/SIS LTD

FINANCE

128

THE McKINSEY QUARTERLY 1998 NUMBER 3

Most applications of option theory have been oversimplified
What happens when options generate more options as well as cashflows?
We oƒfer a second-year course on compound options*

Thomas E. Copeland and Philip T. Keenan
NCE AN OBSCURE MATHEMATICAL TOOL,

options and option valuation have entered the mainstream. Long routinely applied on trading floors, the Black–Scholes model for valuing options won the 1997 Nobel Prize for economics. Yet despite the fact that senior managers realize that traditional analytical methods such as net present value (NPV) and economic profit (EP) have been responsible for systematic underinvestment and stagnation, options have penetrated the decision-making processes of large corporations more slowly.

O

For NPV and EP ignore an important reality: business decisions in many industries and situations can be implemented flexibly through deferral, abandonment, expansion, or in a series of stages that in eƒfect constitute real options (Exhibit
1). Recognizing real options can help decision makers assess the profitability of new projects and understand whether and when to proceed with the later phases of projects that have already been initiated, particularly when they are close
* For the first-year course, see Thomas E. Copeland and Philip T. Keenan, “How much is flexibility worth?,” The McKinsey Quarterly, 1998 Number 2, pp. 38–49.
We wish to acknowledge the contributions of colleagues dealing with real options, including Sam Blyakher, Cem Inal, Max Michaels, Yiannos Pierides, and Dan Rosner.

Tom Copeland is a former principal in McKinsey’s New York oƒfice and Phil
Keenan is a consultant in the Cleveland oƒfice. Copyright © 1998 McKinsey
& Company. All rights reserved.

THE McKINSEY QUARTERLY 1998 NUMBER 3

129

MAKING REAL OPTIONS REAL

Exhibit 1

Recognizing real options
Situations generating real options, by sector
Aerospace and defense
Valuing options in customer contracts (eg, the cancellation of features)
Assembly and machinery
Timing of investment in new factories Automotive
Valuing decisions to modify new car designs well into product development cycles
Banking and securities
Valuing real estate leases
Chemicals
Timing of investment in new factories Consumer/packaged goods
Learning options for new product R&D and test marketing
Electronics
Entry or exit options in the PC assembly business
Energy
Learning options in timing the development of oil and gas fields
Insurance
Valuing such contingency features as loans against value of policies
Media and entertainment
Planning new product launches
Metals
Learning options in timing the development of new mines

Pharmaceuticals and medical products Establishing priorities among prospective R&D projects
Pulp and paper
Timing of forest harvesting
Retail
Timing of expansion into foreign markets Telecommunications
M&A programs for geographic expansion Transportation
The option to extend or contract routing structures (eg, railroad spurs) to breakeven. Real options are especially valuable for projects that involve both a high level of uncertainty and opportunities to dispel it as new information becomes available.*
Although the overall concept of real options is clear, their specific benefits for individual businesses are not. To date, most attempts to apply real options have been too simplistic to address the complexity of the decisions managers face. In deciding whether to finance a research and development eƒfort, for example, managers must reckon not only with technological uncertainty concerning the outcome of the research but also with market uncertainty about the eventual demand for the resulting product. When a company contemplates developing a mine or a natural gas field, both the market price of the output and the level of output are uncertain.
To bring practicality and detail to thinking about real options, we have worked through a series of cases that capture the
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