Have you ever been involved in a capital investment decision where the net present value calculations proved negative, but the management team decided to go ahead anyway? Or been confronted with a positive NPV project where your intuition warned you not to proceed? Often, it is not your intuition that is wrong, but your time-honored NPV decision-making tools.

But there is another way. Managers can use a different tool: real option value. When a situation involves great uncertainty and managers need flexibility to respond, ROV comes into its own. If the decision you face involves low uncertainty, or you have no scope to change course when you acquire new information later on, then NPV works fine. If not, you will want to know more about what real options are and how to value them.

Below, we compare the main decision-making tools and show why traditional techniques such as NPV, economic profit (EP),¹ and decision trees are incomplete, often misleading, and sometimes dead wrong. We also look at how real options have been used in several practical situations, drawing on simple examples for illustrative purposes rather than going into the mechanics of valuing complicated real options.²

Real options...