When a project is uncertain, a company has the right to make definite decisions. Real options allow flexibility and creativity in order to maximize the value of a project, unlike traditional NPV analyses which take into consideration only expected future cash flow. The real options include decisions such as whether to invest or not, the timing of an initial investment, or expanding or contracting operations after implementation.
Valuing real options requires considering two factors: the option’s cost and its potential payoff. The cost is determined by looking at the sunk costs required to make certain decisions – such as those related to researching new projects or technologies – while the potential payoffs are based on how much additional value will be gained from making these decisions. Additionally, other variables such as market conditions and risk tolerance must also be taken into account in order to calculate an accurate value for a given firm’s real options.
Real options and the way they are valued will help you make informed choices about whether to invest in projects uncertain, with high returns but inherent risks.