Real Options and Project Evaluation: a Primer

In this paper we present a preliminary approach to the evaluation of policies and projects based on current thinking on cost benefit analysis and real option methodology and the authors’ recent work on the same subject. We start from the assumption that economic agents undertake investment projects in order to create and exploit opportunities for increasing profits, growth, wealth and, ultimately, their welfare. These opportunities are options, rights and not obligations to take some action in the future. They include not only projects undertaken, but also projects that could be adopted in the future, and opportunities that can be further created or destroyed by this adoption. From the point of view of the welfare of an entire economy, opportunities enlarge the set of actions that may contribute to national wealth. Not only this is increased by the net flow of discounted benefits generated by new ventures, but also by the net value of the options created and destroyed by investment behavior. When companies develop investment opportunities, therefore, they contribute to national welfare in a more subtle, but not less important way, than when they are actively set to exploit some of these opportunities. By recognizing the direct contribution to country wealth of project design and planning, option theory may thus substantially change the theory and practice of decision making about capital investment. The conventional approach implicitly theorizes that investment decisions can be reversed if the conditions change or that they are now-or-never propositions. In contrast, the new way of thinking of investment opportunities as options, changes the premise: irreversibility, uncertainty and the choice of timing alter the investment decisions in critical ways. The real option approach, differently from the traditional tools of project evaluation and capital budgeting, promises to establish a richer framework, both for decision makers and for managers, who should be enabled to address these issues in amore transparent and coherent way. In accordance to this theory, the agent with an opportunity to invest is holding something akin to a financial call option: it has the right but not the obligation to buy an asset at a future time of its choosing. When an agent makes an irreversible investment expenditure, he “exercises” his call option, and doing this it effectively “kills” the option. In other words, by deciding to go ahead with an expenditure, the