Chapter 70. Real Options and Modern Capital Investment Decisions


David & Esther Berlinberg Professor, Vice Provost for Academic Affairs, University of South Carolina

Abstract: It has long been recognized that many capital investments feature options. For instance, an assembly plant may be expanded if product demand warrants, a warehouse may be abandoned, and a construction project may be deferred until market conditions are better. It has also been recognized that traditional capital budgeting tools such as net present value and internal rate of return ignore these features. To fill this void, modern option pricing theory has now found its way into the field of capital investment decision making and is referred to as the real options approach to capital budgeting.

Keywords: real options, capital budgeting, net present value (NPV), investment timing, capital expansion, project abandonment

In this chapter we will see that the traditional methods of analyzing capital proposals and making investment decisions may be readily extended to account for options involving expansion, scale reduction, and timing. We begin by revisiting the net present value (NPV) rule—accept a capital investment if NPV is positive—in light of what we know about the value of options. It turns out that the familiar rule, once suitably augmented, is as useful as ever. We will determine how to value the flexibility to defer investment, and will discover that another familiar rule, the present value ...

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