Manager’s Flexibility & Cancellation Option: Insights of a Case Study in the Latin American Oil Industry

Arthur Ridolfo Neto, Marcelo Moreira Russo

Abstract


Purpose: This article focused on the main business insights of the use of Real Options valuation analysis in the eyes of a finance professional. It used a case study of an investment opportunity in the oil and gas field services industry in Latin America to discuss the methodology implementation and its insights. As a secondary objective, it discussed the insights and options embedded in this investment opportunity.

Methodology: The investment opportunity was examined using the Real Options Analysis (ROA) framework and the results compared to the traditional methodology of Net Present Value. The valuation technique was performed as if it had been applied at the time the project was approved.

Findings: The most important of Real Option valuation is not the results, but how one arrives at them. After the project value is calculated and the project approved or not, the Real Option valuation requires and supports the monitoring of the project. By understanding how the options are created, managers can make better decisions about the project after it was approved.

Practical implications: A relevant contribution from the study was the discussion, as a practitioner, of the methodology implementation in a real world corporation.

Originality & value: The case study evaluated two types of real options: first, the effect of an option to cancel a contract that was assessed from the perspective of the client contracting the project; and second, the option to abandon and defer, from the perspective of the company that will perform the investment to provide the services. By incorporating the cost of the put option that the company puts forth for the client (cancellation option) it reduces the project value by giving flexibility to its clients.



Keywords


Real options, Capital budget projects, Decision under uncertainty, NPV, Option to cancel.

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DOI: https://doi.org/10.15194/jofi_2015.v1.i3.28

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