New tools for investment decision-making: real options analysis

Abstract

<p>Management's ability to alter its future actions in response to changing market conditions can profoundly affect the decision to invest, and undermines standard discounted cash flow rules. The reason is that investment opportunities can be viewed as a collection of options on real assets, or real options. These are exactly analogous to financial options, in that a firm with a discretionary investment opportunity has the right -- but not the obligation -- to acquire the (gross) present value of expected cash flows by making an investment outlay on or before the anticipated date when the investment opportunity will cease to exist. The incorporation of real options analysis into capital budgeting decisions greatly enhances the ability of an organization to assess potential projects. Three simple examples are presented that highlight important real options.</p>