The Real Options Approach to Strategic Capital Budgeting and Company Valuation

Wouter De Maeseneire

A growing number of managers and academics are becoming convinced that the traditional approaches to capital budgeting and valuation are inadequate since they do not properly capture managerial flexibility to adapt and revise later decisions in response to unexpected market developments. Real options uses insights and techniques derived from option pricing theory to enable the quantification of elements of managerial flexibility and strategic interactions in non-financial or real assets, which have thus far been ignored or underestimated by standard valuation tools. An options-based strategic capital budgeting approach may be able to properly quantify not only managerial operating flexibility, but also synergies, inter-temporal dependencies (growth options) and many other strategic aspects of valuation. As part of the strategic capital budgeting process, management should be constantly looking for opportunities to exercise the firm’s available real options or create new ones.

This book serves as an introduction to the exciting field of real options. Numerous examples where traditional NPV provides flawed outcomes are presented to illustrate the main differences between traditional valuation approaches and real options. Various applications of real options are described and the determination of a real option’s parameters and value are extensively elaborated upon. The book concludes with a critical discussion of the real options approach.

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