Investment Opportunities as Real Options: Getting Started on the Numbers

Abstract

T HE ANALOGY between financial options and corporate invest-ments that create future opportuni-ties is both intuitively appealing and increasingly well accepted. Execu-tives readily see why investing today in R&D, or in a new marketing pro-gram, or even in certain capital ex-penditures ¡a phased plant expansion, say) can generate the possibility of new products or new markets tomor-row. But for many nonfinance man-agers, the journey from insight to action, from the puts and calls of financial options to actual invest-ment decisions, is difficult and deeply frustrating. Experts do a good job of explaining what option pricing captures that conventional discounted-cash-flow (DCF) and net-present-value (NPV) analyses do not. Moreover, simple option pricing for exchange-traded puts and calls is fairly straightfor-ward, and many books present the basics lucidly. But at that point, most executives get stuck. Their in-terest piqued, they want to know How can I use option pricing on my project? and How can I use this with real numbers rather than with steril-ized examples? Unfortunately, how-to advice is scarce on this suhject and mostly aimed at specialists, preferably with Ph.D.'s. As a result, corporate analyses that generate real numbers have been rare, expensive, and hard to understand. The framework presented here bridges the gap between the practi-calities of real-world capital projects