The real option approach to investment decision making does not provide a superior alternative to traditional methods
Capital investment decisions are among the most important strategic decisions a company can make. Twenty years ago, managers began to realise that the traditional capital spending decision techniques such as discounting cash flow (DCF) were based on estimated revenues and costs and hence not appropriate in an uncertain arena. It was apparent that flexibility was important and that the real options analysis rewarded flexibility. Over time, managers have tested various capital budgeting techniques and in this paper I shall compare and contrast these tools and conclude whether or not new methods are in fact superior to the traditional ones.
The term real options originally came from Stewart C. Myers of M.I.T. in 1977. He went on to produce a book in which he dedicates a whole chapter to the theory. According to Brealey and Myers (2001), the first to recognise the value of flexibility was Kestor (984) in an article in the Harvard business review. Following that it began to be incorporated in corporate financial strategies, shown to have a range of applica
1) Traditional methods have no operating flexibility. They cannot be expanded, contracted, abandoned or delayed. Real options reward flexibility and allocate value to an investments potential
And it’s not easy. That’s why in general only industries that have plenty of the market and R&D data needed to make confident assumptions about uncertainties in real-option analysis use it. That scenario is changing.
-modelling the interaction between technical options and financial ones