Improving capital budgeting decisions with real options

M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y S U M M E R 2 0 0 8 , V O L . 9 , N O . 4 T he process of evaluating the desirability of long-term investment proposals is referred to as “capital budgeting.” Making optimum capital budgeting decisions (e.g., whether to accept or reject a proposed project), often requires recognizing and correctly accounting for flexibilities associated with the project. Such flexibilities are more formally termed real options.1 From a valuation standpoint, these options are valuable because they allow decision makers to react to favorable or unfavorable new situations by dynamically adjusting the capital budgeting decision process. Unfortunately, the value of real options is not explicitly considered in conventional procedures (such as discounted cash flow (DCF) models) used to evaluate long-term investment proposals. In some sense, therefore, real options can be viewed as an extension of DCF that incorporates a simple model of strategic learning.2 In this article we present a short tutorial regarding real options—what they are and how they can be formally incorporated into the capital budgeting process. We also illustrate how to price a capital investment project containing real options. To explain these concepts to a wide audience in accounting, we take more of an intuitive approach and therefore abstract from more technical treatments of the topic, such as those explicitly linked to the Black-Scholes pricing model for financial options.3 To illustrate basic concepts regarding real options, we use a straightforward example that relates to a rental car company that is considering whether to purchase a conventional gasolinepowered car or a hybrid car as an addition to its rental fleet, a decision complicated by uncertainties regardImproving Capital Budgeting Decisions With Real Options