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Option pricing

Real options in investment appraisal

3.1 Introduction

Flexibility adds value to an investment, BUT conventional investment appraisal
techniques typically undervalue flexibility within projects with high uncertainty.

Real options theory attempts to classify and value this flexibility by taking the ideas of
financial options pricing and developing them.

3.2 Four types of real option

 Option to delay

The key here is to be able to delay investment without losing the
opportunity to invest at some point.

 Option to expand/follow-on

It may be possible to adjust the scale of an investment depending
on the market conditions.

 Option to redeploy / switch

It may be possible to switch the use of assets should market
conditions change.

 Option to withdraw / abandon

If a project has clearly identifiable stages such that investment can
be staggered, then management have to decide whether to
abandon or continue at the end of each stage.

Illustrations and further practice

Now try Illustrations 1-5 and TYU 5 and TYU 6 from Chapter 8

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