INTRODUCTION

Traditional approaches of capital budgeting discounted cash flows are based on a set of static assumptions related to the project payoff and one-time decision-making process, whereas the payoffs in the real scenario are uncertain and probabilistic. Most projects involve contingent decisions, where senior management can change the course of the project by deciding whether to defer the investment for a while; abandon, expand, or contract the project; maintain the status quo; and so on.

There is a great strategic value embedded in these multistaged decisions, which can be taken advantage of only if management recognizes it and is willing to exercise the options and the value of such options must be quantified and captured. Investment strategies with high risks and uncertainty or irreversible corporate decisions coupled with managerial flexibility provide the best candidates for real options.

In other words, companies should apply the notion of options, as conceived in financial options, to their own business situation.

Example:
You have a chance to invest INR 100,000 in a project today that is estimated to yield a return of INR 125,000 one year from now with a 50-50 chance that it may go up to INR 170,000 (good case) or down to INR 80,000 (bad case). But you also have the choice to defer the decision for a year, by which time the uncertainty about the payoff is expected to clear. Discount Rate 15%