Multinational Finance, 6th Edition

Chapter 16Real Options and Cross-Border Investment Strategy

The blunders are all there on the board, waiting to be made.

— Savielly Tartakower

Chapter 13 introduced the NPV decision rule—invest in all positive-NPV projects—and applied this rule to situations encountered in cross-border capital budgeting. In market-based economies, this approach to investment decision making is the overwhelming favorite among companies large and small. Yet companies employing discounted cash flow techniques occasionally make decisions that, at least on the surface, appear to violate the NPV decision rule.

These apparent violations of the NPV rule often arise when valuation models fail to consider managerial flexibility in an uncertain and ever-changing world. As it is usually applied, NPV is a static calculation that fails to consider the many options that managers have to expand, contract, abandon, renovate, accelerate, or delay a project, or respond to new information gained from a project. A real option approach to the investment decision captures managerial flexibility by viewing the investment decision as a real option—an option on a real asset.

Section 16.2 casts the market entry decision as a simple investment option in order to introduce the role of real options in investment strategy. Section 16.3 develops the role of uncertainty. Section 16.4 provides insight into market entry as a portfolio of real options. Section 16.5 discusses the relative merits of traditional and real option investment ...