Microsoft & real options

Hello, I'm Dr. Michael McDonald. I'm an associate professor of finance at Fairfield University, and today I'd like to talk to you about Microsoft and real options.

What are real options? Well, a real option is basically a financial concept that applies options valuation techniques to investment decisions in real assets. In other words, things like factories or research and development decisions, new business ventures, things like that. The idea is that, unlike traditional discounted cash flow analysis, real options recognize managerial flexibility in response to uncertainty. Companies don't just make a go or no-go decision. They can delay, expand, contract, or abandon projects based on market conditions, and real options attempt to incorporate this. For example, we might have an expansion option where we can invest more if conditions are favorable or a deferral option, where we wait for more information before committing capital, or even an abandonment option, where we exit if a project is underperforming our initial expectations at some preliminary point in time.

Why do we use real options? Well, traditional DCF models assume passive management. In other words, we make a go or no-go decision, and then we let the project go, and it's simply off to the races. But in reality, firms adjust their strategies as uncertainty unfolds. It would be a very strange businessperson if they said, "Oh! Well, I've decided I'm going to do this, and no interim events will ever change my mind. I've decided I'm going to build XYZ structure, and even if there is a hurricane or the zoning changes, or costs rise, or anything of the sort, none of that will influence my decision about continuing this project." That's just not realistic. Real options provide a way to quantify strategic flexibility in decision-making. The valuation of real options follows the principles of financial options. We start with our underlying asset and we project cash flows based on that. Then we think about, for the exercise price, what's the cost of our investment? Volatility correlates to our uncertainty in the market conditions, and then time to expiration is essentially the window for making that investment decision. Real options are used heavily in Hi tech, pharmaceuticals, energy, and AI investments, all spaces where uncertainty is high. Now let's talk about Microsoft for a minute.