Any time a firm has the ability to make choices, there is value added to the project in question – Traditional NPV analysis ignores this value. The study of real options attempts to put a dollar value on the ability to make choices. What are real options and how are they valued.

The firm’s decision rights when their project is uncertain are called real options. These options allow flexibility and creativity to maximise value. They are different from traditional NPV analyses which only consider future cash flows. The real options include whether to invest, when and how much, expansion or contracting of operations after the initial implementation, or abandoning a project entirely if they prove too expensive.

Valuing real options requires considering two factors: the option’s cost and its potential payoff. The cost is determined by looking at the sunk costs required to make certain decisions – such as those related to researching new projects or technologies – while the potential payoffs are based on how much additional value will be gained from making these decisions. Additionally, other variables such as market conditions and risk tolerance must also be taken into account in order to calculate an accurate value for a given firm’s real options.

Businesses can make better informed decisions by understanding the real value and working out how options are valued. This will allow them to invest their money in projects with high potential rewards, but also have some inherent risk.