How to use real options in project evaluation

Abstract

An option is a financial instrument that gives the opportunity, but not the obligation, to sell or buy a given financial asset, under predetermined conditions. When used for real (tangible) assets, then we are talking about a real option. The present paper will examine the advantages and disadvantages of using real options in the evaluation of investment projects. The analysis will be presented as a com- parison with traditional discounted cash flow methods. Net present valu (NPV) and other discounted cash flow methods are based on the presumption that expectations for the period of the investment project cannot be changed in the future. So once made, the investment decision remains unchanged. In contrast, real options enable these expectations to be viewed as time varying. This allows managers to be more flexible in their investment decisions