future cash flows. If the NPV is not positive, then the project should be rejected. Note,
however, that traditional capital budgeting theory says nothing about actions that can be
taken after the project has been accepted and placed in operation that might cause the cash
flows to increase. In other words, traditional capital budgeting theory assumes that a proj-
ect is like a roulette wheel. A gambler can choose whether or not to spin the wheel, but
once the wheel has been spun, there is nothing he or she can do to influence the outcome.
Once the game begins, the outcome depends purely on chance, with no skill involved.
Contrast roulette with other games, such as draw poker. Chance plays a role in
poker, and it continues to play a role after the initial deal because players receive addi-
tional cards throughout the game. However, poker players are able to respond to their
opponents’ actions, so skillful players usually win.
Capital budgeting decisions have more in common with poker than roulette because
(1) chance plays a continuing role throughout the life of the project and (2) managers
can respond to changing market conditions and to competitors’ actions. Opportunities
to respond to changing circumstances are called managerial optionsbecause they give
managers a chance to influence the outcome of a project. They are also called strategic
optionsbecause they are often associated with large, strategic projects rather than rou-
tine maintenance projects. Finally, they are called real options,and they are differenti-
ated from financial options, because they involve real, rather than financial, assets.
The first step in valuing projects that have embedded options is to identify the op-
tions. Even though no two projects are exactly identical, several types of real options
are often present, and managers should always look for them. Even more important,
managers should try to create options within projects.
Investment Timing Options
Conventional NPV analysis implicitly assumes that projects will either be accepted or
rejected, which implies that they will be undertaken now or never. In practice, how-
ever, companies sometimes have a third choice—delay the decision until later, when
more information is available. Such investment timing options can dramatically af-
fect a project’s estimated profitability and risk.
For example, suppose Sony plans to introduce an interactive DVD-TV system,
and your company has two alternatives: (1) immediately begin full scale production
of game software on DVDs for the new system or (2) delay investment in the proj-
ect until you get a better idea of the size of the market for interactive DVDs. You
would probably prefer delaying implementation. Keep in mind, though, that the
option to delay is valuable only if it more than offsets any harm that might come from
delaying. For example, if you delay, some other company might establish a loyal
customer base that makes it difficult for your company to later enter the market.
The option to delay is usually most valuable to firms with proprietary technology,
patents, licenses, or other barriers to entry, because these factors lessen the threat
of competition. The option to delay is valuable when market demand is uncertain,
but it is also valuable during periods of volatile interest rates, since the ability to
wait can allow firms to delay raising capital for projects until interest rates are
lower.
Growth Options
A growth option allows a company to increase its capacity if market conditions are
better than expected. There are several types of growth options. One lets a company
increase the capacity of an existing product line. A “peaking unit” power plant illustrates
this type of growth option. Such units have high variable costs and are used to pro-
duce additional power only if demand and therefore prices are high.
Introduction to Real Options 635
630 Option Pricing with Applications to Real Options
