USE OF REAL OPTIONS IN PROJECT VALUATION

Traditional project evaluation reasoned on discounted cash flow methods ignores the potential of the investment from innovations, research and development (R&D), strategic management flexibility when net present value is low or negative. A real options approach extends the value of a project by supplementing the value of options. It views capital and project investment strategy as the value of NPV and a series of options that can be continually exercised to archive both short and long term returns on investment and better reflect the dynamic and changing reality of business. This paper reviews the differences in assumptions between the traditional and real options approach, the characteristics and methodologies of Black-Scholes, Binomial valuation. The objective in the last section is pricing the option to expand, defer, compound and abandon the project.