A company is considering investing 2 million on improving its services. This is

Question

A company is considering investing 2 million on improving its services. This is justified on the grounds that it will allow the business to extend the range of products offered. In particular the management are interested in selling electronic gadgets and have estimated the following with the gadget busines:

T=1, Cost=5 million, PV net receipts = 4 million, volatility=40% and risk free rate = 5%.
Answer the following:
Should the retailer proceed with investing in the ordering system based on the gadget business?
And
Discuss what real options are and how they can be used by a firm?
Please include details.

Explanation / Answer

Looking at a glance it does not seem viable to invest in such a business which will cost the company $5mn per year and an initial investment of 2 mn to improve its services. This coupled with such high volatility of 40% does not seem practical to go with. In the longer term a wide range services or electronic gadgets may bring profitability but doesnt seem viable as of now..

Real options are derivatives which are the financial instruments used for hedging risks. They give the investors an option for buying or selling a security at a pretermined price within a fixed period. The markets for real options is becoming huge and can be used by the firms in a profitable way. Firms which have confidence in their businesses can offer real options for their investors thereby getting raising higher equity which can be used to further enhance the business by taking up positive NPV projects. Firms are already issuing real options and they are traded in the F&O market.

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