What is real options analysis (ROA) as it applies to entrepreneurship and when is it appropriate to be used in this context?

Question

What will be an ideal response?

Answer 1

Real options analysis (ROA) is an investment analysis tool from the field of finance. It has been increasingly adopted by consultants and executives to support strategic decision making in firms. Applied to entrepreneurship, real options suggest a path that companies can use to manage the uncertainty associated with launching new ventures. The concept of options can also be applied to strategic decisions where management has flexibility. Situations arise where management must decide whether to invest additional funds to grow or accelerate the activity, perhaps delay in order to learn more, shrink the scale of the activity, or even abandon it. Decisions to invest in new ventures or other business activities such as R&D, motion pictures, exploration and production of oil wells, and the opening and closing of copper mines often have this flexibility. Important issues to note are: (1) ROA is appropriate to use when investments can be staged; a smaller investment up front can be followed by subsequent investments. Real options can be applied to an investment decision that gives the company the right, but not the obligation, to make follow-on investments; (2) Strategic decision makers have tollgates, or key points, at which they can decide whether to continue, delay, or abandon the project. Executives have flexibility. There are opportunities to make other go or no-go decisions associated with each phase; and (3) It is expected that there will be increased knowledge about outcomes at the time of the next investment and that additional knowledge will help inform the decision makers about whether to make additional investments (i.e., whether the option is in the money or out of the money).