Lesson 10 of 11 · All lessons in this module
- Present value and discount (zero-coupon) bondsVideo lesson
- Coupon bonds and perpetual bonds
- Level-payment instruments: mortgages and amortizing loansVideo lesson
- Valuing shares with dividend discount models
- Implied returns on bonds
- Floating-rate coupons and spreadsheet TVM functions
- Required return, implied growth and the P/E ratio
- Cash flow additivity, no arbitrage and forward rates
- No-arbitrage pricing of FX forwards and options
- Valuing a real option with cash flow additivity
- Integrated cases: bills, forward rates and currency forwards
This lesson is part of the 2027 curriculum. You are following the 2026 curriculum, where it is not taught in this form. Switch if you are sitting the exam under the 2027 curriculum.
Lesson 10 of 11 · 11 min
Valuing a real option with cash flow additivity
A real option is the right, but not the obligation, to change a project later; cash flow additivity values it as the present value of the extra cash flows it creates, net of what it costs to exercise.
In short
- A real option is managerial flexibility in a real investment: the right but not the obligation to defer, abandon, expand or contract a project.
- By cash flow additivity, project value with the option = project value without it + value of the incremental cash flows the option creates.
- Option value = PV of the incremental cash flows − PV of the exercise cost, both discounted to today.
- Exercise only if the incremental cash flows are worth more than the exercise cost at the decision date; otherwise walk away, so the option is never worth less than zero.
- A project with a negative NPV on its own can become worthwhile once a valuable option is counted.
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