How Much is Flexibility Worth

Abstract

When a situation involves great uncertainty and managers need flexibility to respond, real options valuation comes into its own. If the decision you face involves low uncertainty, or you have no scope to change course when you acquire new information later on, then NPV works fine. If not, you will want to know more about what real options are and how to value them. We compare the main decision-making tools and show why traditional techniques such as NPV, economic profit (EP), and decision trees are incomplete, often misleading, and sometimes dead wrong. We also look at how real options have been used in several practical situations, drawing on simple examples for illustrative purposes rather than going into the mechanics of valuing complicated real options.

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