Handbook of Finance: Investment Management and Financial Management

Chapter 69. Real Options

JOHN D. FINNERTY, PhD

Professor of Finance and Director of the MS in Quantitative Finance Program, Fordham University Graduate School of Business

Managing Principal, Finnerty Economic Consulting, LLC

Abstract: A firm's capital investment opportunities include valuable options that the firm should explicitly consider during project evaluation. The traditional DCF method ignores the extra value associated with real options, such as the possibility of deferring the start of the project or proceeding in stages to take advantage of new information the firm might obtain or advances in technology that might occur over time. In contrast, real-options analysis allows the firm to value these options explicitly and calculate a more inclusive value for each project. Real-options analysis is very useful in evaluating projects that consist of two or more discrete stages at the end of which the firm will decide whether to continue the project or abandon it. The analysis indicates what corporate action is value-maximizing at each stage of the project, contingent on the information available at the time. It is especially useful for large projects, such as natural resource development, where a firm would like to defer committing to spend large sums on final development until it is reasonably certain the investment is worthwhile.

Keywords: real options, real-options analysis, deferral option, abandonment option, exploration option, development option, discounted cash flow (DCF), ...