The role of real options in capital budgeting: Theory and practice

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Abstract

Most discussions of capital budgeting take for granted that discounted cash flow (DCF) and real options valuation (ROV) are very different methods that are meant to be applied in different circumstances. Such discussions also typically assume that DCF is “easy” and ROV is “hard”—or at least dauntingly unfamiliar—and that, mainly for this reason, managers often use DCF and rarely ROV. This paper argues that all three assumptions are wrong or at least seriously misleading. DCF and ROV both assign a present value to risky future cash flows. DCF entails discounting expected future cash flows at the expected return on an asset of comparable risk. ROV uses “risk-neutral” valuation, which means computing expected cash flows based on “risk-neutral” probabilities and discounting these flows at the risk-free rate. Using a series of single-period examples, the author demonstrates that both methods, when done correctly, should provide the same answer. Moreover, in most ROV applications—those where there is no forward price or “replicating portfolio” of traded assets—a “preliminary” DCF valuation is required to perform the risk-neutral valuation. So why use ROV at all? In cases where project risk and the discount rates are expected to change over time, the risk-neutral ROV approach will be easier to implement than DCF (since adjusting cash flow probabilities is more straightforward than adjusting discount rates). The author uses multi-period examples to illustrate further both the simplicity of ROV and the strong assumptions required for a typical DCF valuation. But the simplicity that results from discounting with risk-free rates is not the only benefit of using ROV instead of—or together with—traditional DCF. The use of formal ROV techniques may also encourage managers to think more broadly about the flexibility that is (or can be) built into future business decisions, and thus to choose from a different set of possible investments. To the extent that managers who use ROV have effectively adopted a different business model, there is a real and important difference between the two valuation techniques. Consistent with this possibility, much of the evidence from both surveys and academic studies of managerial behavior and market pricing suggests that managers and investors implicitly take account of real options when making investment decisions.
Original languageEnglish
Pages (from-to)28-39
JournalJournal of Applied Corporate Finance
Volume18
DOIs
StatePublished - 2006

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