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Real Options Theory

Real Options Theory is an important new framework in the theory of investment decision. The standard theory it modifies is the Expect Net Present Value theory of investment decision. According to NPV theory the future cash flows of an investment project are estimated and if there is uncertainty about those cash flow the expected value determined. The expected cash flows are discounted at the cost of capital for the corporation and the results summed. If the NPV is positive the project is worthwhile and should be pursued. If it is negative the project should be turned down. If the NPV is zero it does not matter to the corporation whether the project is accepted or rejected.

Where NPV theory is dificient and where Real Options theory fills the gap is where subsequent decisions can modify the project once it is undertaken. NPV makes no provision for this flexibility of the project and consequently undervalues its benefits. In the auction of petroleum explaration contracts it was commonplace for the highest bids to exceed the net present value calculation. This is because the successful bidder knew that once some initial drilling was done the company could, on the basis of that information, stop the exploration or expand the exploration.

Real Options Theory is related to decision tree analysis which in turn is related to Richard Bellman's Dynamic Programming. What Real Options Theory adds to the past methods of optimal sequential decision-making is is the formal theory of the valuation of options, which was pioneered by Fischer Black, Myron Scholes and Robert C. Merton.


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