The traditional method of analyzing corporate projects, referred to as capital budgeting, involves discounted cash flow computations to determine the project's net present value (NPV). This computation is done using the expected cash flows associated with a project, and works well for projects with characteristics that do not change over time. In practice, the management of projects is dynamic in nature, and managers have flexibility to make decisions as information is received over the life of a project. The actual cash flow that is realized in each year is usually greater than or less than the expected value, reflecting changing market conditions and managerial decisions. Many projects, especially those with a significant technological component, are characterized by a high degree of flexibility. This flexibility cannot easily be reflected within discounted cash flow analysis and an NPV computation. A more appropriate method for the evaluation of technology projects is real-options analysis.
Real options analysis involves the application of option-pricing theory to the valuation of physical assets such as corporate projects. Option-pricing theory has been well developed and widely applied to financial assets such as stocks, commodities contracts, and foreign currency. Its application to real assets is a more recent phenomenon, with applications in venture capital investment (Li, ...