What Is the Real Options Approach to Capital Budgeting?
Real options is the modern approach to capital budgeting. This approach considers the value of the opened options for the decision makers. The origin of the term “real options” can be attributed to the Prof. Stewart Myers (“Determinants of Capital Borrowing”, Journal of Financial Economics, vol.5, 1977), who first identified the fact that many corporate real assets can be viewed as call options. The real options approach is dynamic in the sense that includes the effect of uncertainty along the time, and what/how/when the relevant real options shall be exercised. The real options problem can be viewed as a problem of optimization under uncertainty of a real asset (project, firm, land, etc.) given the available options. Although Black-Scholes-Merton and financial options came first in the 70’s, and the mathematical methods are the same, real options approach is not a mere adaptation of financial options approach. There are several differences between real options and financial options. F
