13.4 Real Options in Capital Budgeting
The NPV provides the proper tool for evaluating whether a project is expected to add value to the firm. However, it is generally calculated using a static set of expected future cash flows that do not reflect the fact that managers are likely to make changes to the operation of the investment over its life in response to changing circumstances that alter the profitability of the investment. For example, if a project that had an expected life of 10 years generates better-than-expected cash flows, management may extend its life to 20 years, or if its cash flows do not meet expectations, management may decide to scale it back or shut it down prematurely.
Having the flexibility to alter an investment’s scale, ...
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