TABLE OF CONTENTS The discounted cash flow (DCF) method and decision tree analysis (DTA) are standard tools used by analysts and other professionals in project valuation, and they serve the purpose very well in many applications. However, as discussed in the previous chapter, these tools have certain limitations. For example, if there is large uncertainty related to the project cash flows and contingent decisions are involved, where mangers have flexibility to change the course of the project, some of the value is not accounted for by these tools. In this chapter, we demonstrate how that additional value can be captured by real options. We also compare and contrast real options analysis (ROA) with DCF and DTA.
Let s start with a simple example to illustrate how the real options approach is different. You have a chance to invest $100 in a project. The payoff is expected to be between $60 and $160 with an average of $110. The DCF analysis, which does not account for the uncertainty, will put the net present value (NPV) at $10. Assume that this return does not meet your corporate standard; therefore, your decision will be not to invest in the project. But what if an initial small investment (say $10) will help settle the uncertainty and give you an option to fully invest in the project at a later date only if the return is favorable but abandon it otherwise? You are likely to accept this idea. When the uncertainty...
