Real Options Analysis For Risky Projects

Companies and organisations make capital investments to exploit opportunities and maximise shareholder value. Whilst the management tools and techniques to develop physical assets and labour are well known and easily applied, the ability of senior managers to evaluate and manage the optimum strategic direction of the firm in the presence of knowledge assets or innovation, however, leaves much to be desired.

Traditional methods of analysing opportunities use Discounted Cash Flows (DCF) to evaluate the ability of the opportunity to create wealth. The technique[1] estimates the risk and the implied return (to compensate for risk), as a ‘cost of capital’, and uses this cost of capital to discount future cash flows over a time horizon (represented by the life of the asset). These discounted cash flows are netted against the initial outlay to provide a Net Present Value (NPV). If the NPV is positive, the opportunity is assumed to have generated shareholder wealth.

Managers use variants of this method to calculate the Internal Rate of Return (IRR), Cash Flow Return on Investment (CFROI), Adjusted Present Value (APV) and Economic Value Added (EVA) to provide similar results.

In some cases where additional depth is perceived to be required, decision trees analysis (DTA) is used to map out all feasible or alternative managerial actions, contingent on probabilities being applied. DTA permits the analytical process to recognise interdependencies between the initial and subsequent decisions. These regrettably use the same cost of capital to discount subsequent cash flows, despite there being changing risks at each node on the tree, making the analysis questionable.

Sensitivity analysis to cater for changing risks is another tool. At its apex it includes the use of ‘Monte Carlo’ techniques to simulate thousands of possible outcomes, but which typically fail to address the value of waiting instead of investing and/or, having invested, to value the possibility of abandoning a project to mitigate risk.

The fundamental problem with all these analytical techniques is that they assume the firm is faced with a now-or-never investment decision at the start of the valuation process, that there is no time to wait, that investments will be made in single lump sums at finite moments in time, and that management, after resolving key issues at the start of the process, will remain passive thereafter as events unfold.

When faced with innovation and knowledge-based intangibles, the approach is not to value many such innovation-led opportunities until they mature to the point when they can no longer be deferred, (ergo the firm is faced with a now-or-never decision again). Alternatively there is a tendency to underestimate or even worse, to overheat cash flow projections to impossible levels. This is precisely the reason for the demise of the ‘dot-com’ revolution.

Managers and entrepreneurs on the other hand do no such thing. They prefer to invest in stages (leaving room to abandon at any time and mitigate their losses), or to delay the investment and resolve some or all of the uncertainty surrounding a project. Corporate managers operating in fiercely competitive or uncertain markets therefore need robust analytics and tools that reflect this flexibility.

There is therefore a dysfunctional gap between the DCF/NPV based strategic analysis of a project and what managers actually do. The greater the risk and uncertainty, the greater is this dysfunctional gap. In the event, managers then justify investments for ‘strategic reasons’, to circumvent the planning process entirely, placing the company at great risk.

Real Options – the concept

An option is the right but not the obligation to take an action in the future. Options are therefore valuable when there is uncertainty and when there is sufficient time for all, or many, outcomes to occur.

A firm that develops a leading innovation holds an option to develop the innovation at a moment of its choosing, or having developed the option has the right to abandon it. These embedded options give managers the right but not the obligation to take actions in the future (instead of the now-or-never choices in standard DCF evaluation methods).

Real options are options that are not traded but embedded in the investment decisions managers make. Managers may choose to exercise the option to invest and capture the immediate benefits of an investment, delay an investment to resolve uncertainty, stage an investment to learn or mitigate risk, or expand, contract or even abandon a project or parts of a project at any given time.

Opportunities are therefore seen as real options that can be undertaken immediately to capture first-mover advantages and early cash flows, or delayed to resolve uncertainty. Conversely, early exercise effectively kills the option to wait. This approach has had a profound effect on capital decision making, particularly under conditions of risk, uncertainty and even irreversibility [2].

Real Options in Use

From the late ’90s onwards Option Pricing Theory (OPT) to value Real Options has become increasingly popular in evaluating high-risk large infrastructure projects, developing oil and gas fields, pharmaceutical drugs and even investment in high-tech software, assets and intangibles. There is a considerable amount of information on the use of Real Options Analysis in a wide variety of conditions specific to different industries.

By and large two clear techniques have emerged in support of managerial decision making…

  • The academic approach using customised closed form equations for specialised high risk and/or long gestation capital investments. These techniques approximate the resulting partial differential equations to value the embedded options. Much of this literature is driven by academics or through academic institutions. The academic approach is popular with government bodies and very large infrastructure projects with managerial staff savvy with very high order mathematics;
  • The practitioners approach. These techniques use computing power and management-friendly mathematics to approximate the underlying theory by building binomial or even multinomial decision trees that provide a visual representation of management decision making at discrete intervals.

Real Options versus NPV

Real Options do not replace traditional DCF based methods. They augment them. In all real options valuations the start point is the NPV analysis of a project. NPV is treated as the ‘value without managerial flexibility’. A strong positive NPV provides no further advantage in waiting. Managers would be well advised to invest and capture early cash flows.

Where the project has a strong negative NPV (beyond the ability of the firm to easily bear), there is no justification for investing. A dog of a project will remain a dog, and investing to gain from a future, high-risk and uncertain outcome is throwing good money after bad.

Real Options work best on marginal projects (zero, or marginal plus or minus NPV) or in staged investments where the upside value is very high but there is high risk and uncertainty. In such projects the value of the embedded options in each projects are calculated for different degrees of volatility. The total value of the project is therefore…

Total Value = NPV (value without flexibility) + Real Options Value (value of flexibility)

Real Options are therefore immensely valuable in the presence of uncertainty. The strategic flexibility they offer in many cases outweigh the original reason for the investment, as their greatest value lies in precisely those conditions that are severely punished by traditional evaluation.

Limitations in the use of real options

Managers have hitherto been reluctant to use real options because of the mathematical complexity of the process requiring them to deal with academically challenging stochastic equations. The practitioners approach using decision trees have made this technique much easier to comprehend. The real problem in real options analysis these days is recognising the embedded option. The actual valuation process is relatively easy.

As a case in point, the decision to exercise the right to invest in infrastructure involves capital investment spread over a period of several years, which in turn contain a series of staged compound options. Finding the decision points and setting the decision rules for exercise are a critical part of the process that are not understood, or are largely ignored by managers and consultants alike.

Managers also tend to become emotionally attached to the projects they espouse (or are afraid of failure), and consequently use Real Options to justify projects that would otherwise be rejected. Where the separation between management and the shareholders of the company is distinct and the ‘agency’ issues are a concern this is a genuine problem.

Many Real Options come with ‘obligations’ which are akin to the seller’s position in option theory. Dealing with obligations in underlying embedded options often results in management overstating or understating the value of these options.

Since real options are most valuable in the presence of uncertainty, the accurate estimation of volatility is crucial. In simple situations where volatility is based on previous history (e.g. the price of silver when developing a mine), previous estimates of volatility can be used as a proxy. More often than not, estimating volatility can be a fractious affair particularly when dealing with new products with no earlier history.

There is a further problem with real option valuations where there is more than one source of uncertainty and volatility, making the calculations fairly complex with the use of multinomial equations and complex decision matrices.

Real Options Analysis - comparison between traded options and real options


Real options are options that are not traded but embedded in the investment decisions managers make. Managers may choose to exercise the option to invest and capture the immediate benefits of an investment (standard NPV method), or delay a project/investment to resolve uncertainty, stage an investment to mitigate risk, or expand, contract or even abandon a project or parts of a project at any given time.

The risk is mitigated because the downside risk is removed. Managers will not exercise the right to invest unless they have resolved the uncertainty and are confident of the upside. If the downside eventuates, the option to invest will not be exercised.

Real Options correspond to ‘Call Options’ when they provide management with the ‘right’ but ‘not the obligation’ to learn, delay, defer, expand or stage an investment.

Conversely they are analogous to ‘Put Options’ when they permit management the ‘right’ but ‘not the obligation’ to contract or even abandon a project at any time in its life.

The exercise price is the outlay for call options and the abandonment or scrap value for put options.

Allan Rodrigues is a recognised practitioner in Real Options Analysis and Valuations for high-risk projects and strategies, or large infrastructure projects being undertaken in uncertain markets. You can contact him at




  1. Capital Asset Pricing Model (Sharp and Lintner) and WACC under Imputation (Officer, 1994).
  2. Some investments are irreversible and represent very high risk, e.g. a firm has a plot of land and the choice of building a housing complex or developing a golf course instead. Both choices come with different commercial risks but one choice (the housing complex) is irreversible. If you go down this route you can never build the golf course. Conversely if you build the golf course, you can always cut your losses and build the housing complex later.