Corporate Finance

A Real Option’s Perspective of Capital Budgeting 
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investment is Rs 97.1 lac, the NPV is Rs 3 lac. Based on the NPV, most managers would go ahead with the
project. But the NPV does not deal with the management’s ability to time the project. Suppose the management
has the option to wait for 1 year, at which time they can decide to invest. If the demand for the product turns
out weak, the management can decide not to invest as it does not make sense to invest Rs 97.1 lac and
receive Rs 90 lac a year later. However, if the product turns out to be popular, the project would yield Rs 130
lac for an investment of Rs 97.1 lac. The NPV in this case is Rs 21.2 lac. Since there is a 50:50 chance of a
good outcome (NPV 21.2 lac) and a bad outcome (don’t invest; 0 NPV in year 1), the expected value is (0.5
× 2.12 + 0.5 × 0) Rs 10.6 lac. The present value at year 0 is Rs 96.1 lac. The moral is: there is a value attached
to the option to defer. By not considering the option managers will miss out on a chance to add value by
waiting. In other words, options are exercised only if they have value and are left unexercised if worthless.
A brief study of the decision tree shows that time and the range of outcomes are key to option value.
The Black–Scholes model is a narrow case of the binomial model. It applies when the limiting distribution
on asset and assumes a continuous price process.

TYPES OF REAL OPTIONS

The first step in real options analysis is to identify them. Exhibit 12.2 presents a list of some common real
options we would encounter.

Exhibit 12.2 Common real options

Scale

up

Switch

up

Scope

up

Study/

start

Scale

down

Switch

down

Scope

down

Invest/

grow

Defer/

learn

Disinvest/

shrink

Real

Option

Category

Real

Option

Type

Well positioned businesses can scale up

later through cost-effective sequential

investment as market grows

A flaxibility option to switch products,

process on plant given a shift in underlying

price or demand of inputs or outputs

Investments in proprietary assets in one

industry enables company to enter another

industry cost-effectively. Link and leverage.

Delay investment until more information

or skill is acquired

Shrink or shut down a project part way

through if new information changes the

expected payoffs

Limit the scope of (or abandon) operations

in a related industry when there is no further

potential in a business opportunity

Switch to more cost-effective and flexible

assets as new information is obtained

• High technology


• R&D intensive


• Multinational


• Strategic acquisition


• Capital-intensive industries


• Financial services


• New product introduction


• Airframe order cancellations


• Small-batch goods producers


• Utilities


• Fanning


• Companies with lock-in


• De facto standard bearers


• Small-batch goods producers


• Utilities


• Conglomerates


• Natural resource companies


• Real estate development

Description Examples

Source: Copeland, Thomas E and Philip T. Keenan (1999). ‘How Much is Flexibility Worth?’, The Mckinsey Quarterly, No. 2.