The real option approach to investment decision making does not provide a superior alternative to traditional methods.
Introduction.
Capital investment decisions are among the most important strategic decisions a company can make. Twenty years ago, managers began to realise that the traditional capital spending decision techniques such as discounting cash flow (DCF) were based on estimated revenues and costs and hence not appropriate in an uncertain arena. It was apparent that flexibility was important and that the real options analysis rewarded flexibility. Over time, managers have tested various capital budgeting techniques and in this paper I shall compare and contrast these tools and conclude whether or not new methods are in fact superior to the traditional ones.
Real options.
The emergence of real options.
The term real options originally came from Stewart C. Myers of M.I.T. in 1977. He went on to produce a book in which he dedicates a whole chapter to the theory. According to Brealey and Myers (2001), the first to recognise the value of flexibility was Kestor (984) in an article in the Harvard business review. Following that it began to be incorporated in corporate financial strategies, shown to have a range of applications and Brennan and Schwartz (1985) applied option pricing techniques from finance to the evaluation of natural resources. Originally restricted to application in natural resources such as gold, copper, gas and oil, its uses have extended to a wide range of industries such as software, pharmaceuticals, biotechnology and aircrafts. This requires some innovation. The underlying asset of the option is no longer a traded product such as oil, who's going price can be plugged easily into a formula. Now, the asset that you get with the call option is something that's not traded, for example, a factory that has not been built yet. (Coy, P. 1999).
Applying real options.
Although real options have created a way of measuring market risk in many types of project, further investigation is still required.