June 22, 2008
June 22, 2008
June 25, 2008
13.1023.1 - 13.1023.11
Real Options in Engineering Economy Education Abstract This paper presents the results of a survey of engineering economy educators that service a wide variety of students across various disciplines and levels. We confirmed our hypotheses that real options are not being taught at the undergraduate level due to the material being advanced and that many engineering economy educators are not well prepared to teach the topic. We compare these results with those that teach traditional sequential decision-making techniques, such as decision-trees, and methods of dealing with uncertainty, such as sensitivity analysis and simulation. A recommendation is made regarding what methods should be included in undergraduate and graduate coursework in engineering economy.
Introduction Real options analysis is a tool intended to value flexibility in future choices. The theoretical foundation for real options begins with options on financial securities. For example, a call (put) option gives the holder the right to buy (sell) a certain number of shares at a specified price within a specified period. The option premium is the price paid for the option. The extension into real options can be illustrated by an oil firm that continues to lease potential development tracts even though development is not currently economic. Paying for the real option can be the best choice, because of the possibility that improved technology, higher prices, or infrastructure extensions paid for by other prospects will make the development economic.
Real options analysis uses the mathematics of financial options to provide an Expanded Net Present Value (ENPV), which adds the value of the option to traditional NPV analysis. Thus, real options analysis is another tool in the engineering economic analysis set that has long included decision trees, sensitivity analysis, and simulation. The questions addressed in this paper focus on coverage of real options in engineering economy courses. This is intended to complement research on why the application of real options analysis has not been widely embraced. One reason is that many engineering managers are uninformed regarding the technique. We suggest that another reason is that real options add the most value when decisions are unclear (near-zero NPV), and the mathematics are supported by good data - that is the future benefit stream can be forecasted with identified sources of uncertainty. While options analysis has received wide attention in advanced finance coursework, its application to engineering economy and real engineering projects has been more limited. However, options analysis has been a significant issue in engineering economy research, and one that regularly appears in our literature. How familiar are we as engineering educators with real options analysis? Are we teaching real options to our students? We found no information in the literature regarding these questions.
Historical Development of Real Options Financial options were developed in the early 1970s in academia. The famous Black-Scholes equation was developed by Fischer Black of the University of Chicago and Myron Scholes of MIT’s Sloan School of Management1. They worked closely with Robert Merton, also of MIT2. Scholes and Merton were awarded the 1997 Nobel Prize in Economics for their work (Fischer Black had died in 1995). This work led to improved valuation for the trading of financial
Lewis, N., & Eschenbach, T. (2008, June), Real Options In Engineering Economy Education Paper presented at 2008 Annual Conference & Exposition, Pittsburgh, Pennsylvania. 10.18260/1-2--3563
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