Real Options

Overview

Real options theory applies financial option pricing logic to corporate investment decisions. It recognizes that managers can adapt their decisions as uncertainty resolves — deferring, expanding, contracting, or abandoning projects. Traditional NPV, which assumes a now-or-never commitment, systematically undervalues projects with significant flexibility.

When to Use

• Evaluating investments with high uncertainty and managerial flexibility
• Comparing staged vs. committed investment strategies
• Valuing natural resource extraction, R&D, or platform investments
• When NPV is near zero but the project has strategic optionality

When NOT to Use

• For routine, low-uncertainty investments where NPV suffices
• When flexibility is contractually or practically absent
• If the option exercise conditions are unclear or unquantifiable