0 It is now widely understood that conventional economic analysis based on discounted cash flow (DCF) methods fails to capture the strategic impact of projects. In particular, DCF methods ignore the flexibilities that give project managers options to revise decisions in response to changing exogenous economic conditions. importance of such operating options becomes critical when the environment is highly volatile and the technology is flexible, thus permitting managerial intervention at little cost. For example, when facing exogenous stochastic prices a project with operating options can protect itself against some of the adverse price movements by switching into an alternative mode of operation that is less affected by the adverse price realizations. In effect, the irreversibility assumption of conventional investment analysis is violated. Real options techniques, by endogenizing the optimal operating rules and explicitly capturing the flexibility and its effects on uncertainty, provide for a consistent treatment of risk in the valuation of flexible projects. growing literature on real options has revealed several important lessons:1 (i) the volatility of prices becomes an important determinant of investment, both in terms of the type of investment (e.g., rigid versus flexible technologies) and in terms of the quantity of investment (in that high volatility increases the value and Tobin's q of flexible systems); (ii) the value of flexibility per se may be determined explicitly, given the dynamics for relative model described in this paper is based on an earlier working paper entitled The Value of Flexibility, MIT-EL 86-014WP. empirical results are extensions of the results from an unpublished research project that I conducted with David Wood, with the assistance of Michael Provance and Yoshiki Ogawa at the Center for Energy Policy Research at the MIT Energy Laboratory. project was interrupted by the untimely death of David Wood. paper would not be possible without his contributions, and hence is really a joint product. However, I am solely responsible for any errors. 1See Pindyck [ 13] for a review of the literature on irreversible investments under uncertainty. Kulatilaka and Marcus [9] provide a more intuitive discussion of real options and their implications. Mason and Merton [10] contains a general technical discussion of issues related to the use of options techniques in capital budgeting.
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