Lesson 7 of 7 · 13 min
Real options
Real options give management the right, but not the obligation, to change a project later, and that flexibility can turn a rejected project into an accepted one.
In short
- A real option is like a financial option on a real asset: a right, not an obligation, to act later as events unfold.
- Timing options: delay or sequence an investment to learn more first.
- Sizing options: abandonment if results disappoint; growth (expansion) if they are strong.
- Flexibility options: price-setting and production flexibility once the project is running. Fundamental options: value depends on an outside price such as oil or gold.
- Evaluate with: NPV without options (a minimum if positive); Project NPV = NPV without options − option cost + option value; or decision trees and option pricing models.
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