There are four components in the manager's toolkit for valuing investment
opportunities: payback rules, accounting rates of return, net present
values (NPV) and real options.

Payback rules ask how many periods management must wait before cumulated
cash flows from the project exceed the cost of the investment project.
If this number of periods is less than or equal to the firm's benchmark,
the project gets the go-ahead. Subsequent cash flows, whether positive
or negative, are not factored into the calculation.

One example of an accounting rate of return is the ratio of the average
forecast profits over the project's lifetime (after depreciation and
tax) to the average book value of the investment. Again comparison with
a threshold rate is sought before investment goes ahead.

Both these measures enjoy the benefit of simplicity. Cash flows are
easier to forecast in the near future than the distant future, so a
payback rule can be implemented more accurately. And accounting rates
of return are computed from data that is routinely compiled by management
accountants, making comparison and monitoring relatively easy.

To implement NPV, we need estimates of expected future cash flows and
an appropriate discount rate. And there's the rub. An NPV calculation
only uses information that is known at the time of the appraisal. To
borrow a popular metaphor, think of poker. The ante is $1, say, and
you bet between $1 and $10 on every open card. How much would you place
as your final bet before the first card had been dealt?

This example brings out starkly the problem of uncertainty. You are
being asked to make an NPV calculation using only what is known before
the game begins. And your choice is all-or-nothing, not an initial choice
followed by more choices as information becomes available. In poker,
players pay a small amount to stay in the game. Depending on the next
turn of the card, they then fold, match or raise the bet.

NPV techniques were first developed to value bonds. There is little
investors in bonds can do to alter the coupons they receive or the final
principal paid (the future cash flows), or the yield rate (the appropriate
discount rate). Companies, however, are not passive investors: managers
have the flexibility to sell the asset, invest further, wait and see
or abandon the project entirely.

It is precisely the way in which real options deal with uncertainty
and flexibility that generates their value. Real options are not just
about "getting a number", they also provide a useful framework for strategic
decision making.

So what is a real option? It is the right - but not the obligation
- to acquire the gross present value of expected cash flows by making
an irreversible investment on or before the date the opportunity ceases
to be available. Although this sounds similar to NPV, real options only
have value when investment involves an irreversible cost in an uncertain
environment. And the beneficial asymmetry between the right and the
obligation to invest under these conditions is what generates the option's
value.

Consider an investment project where there is uncertainty about the
state of the world. Suppose it can be either good or bad and it's as
likely to be one as the other. If it is good, your investment project
returns $5. If it is bad, you lose $6. An option to invest in this project
is available for the irreversible cost of $1.

An NPV calculation, where you invest now or never, values the project
at 50%x$5 - 50%x$6 = -$0.50. If you sink $1 and wait and see, the real
option value of the project is 50%x$5 - 50%x$0 - $1 = $1.50 as you don't
have to invest if the state of the world is bad. So flexibility can
be profitable!

This flexibility has several strategic forms.

- Using real options values the ability to invest now and make follow-up
investments later if the original project is a success (a growth option).
These kinds of options characterise pharmaceutical R&D rather well,
for example.

- Real options can also value the ability to abandon the project if
it is unsuccessful (an exit option). A North Sea oil company has had
much well-publicised success valuing its 5-year oil and gas exploration
licenses in this way.

- And real options can value the ability to wait and learn, resolving
uncertainty, before investing (a timing option). Eurotunnel has a
statutory option on a second tunnel under the English Channel, to
be opened not earlier than 2020 (its lease on the first tunnel expires
in 2052). The current fixed link came in one year late and 11 billion
over budget. What price the ability to resolve uncertainty this time?

If real options only have value when costs are sunk and returns uncertain,
what exactly determines their value? In order to exercise a real option,
you must pay the exercise price. The less you pay the better. So the
option's value increases with the ratio of cash flows (returns) to investment
cost (exercise price).

Similarly, you don't have to incur this investment cost until you decide
to exercise the option. Therefore a real option is a free loan, and
its value increases with the interest rate and the length of time before
you invest.

And the option holder does not lose from increased uncertainty if things
turn out wrong but gains if they turn out right. More uncertainty increases
the likelihood of larger positive payoffs, and therefore the value of
an option, as larger down-sides can be avoided.

In what kind of situations should you use real options? A useful taxonomy
classifies real options by whether they are proprietary or shared, whether
they are simple or compounded (options on options) and whether the option-decision
expires or can be deferred.

As you move from proprietary, simple, expiring options (like routine
maintenance of capital equipment) along the spectrum towards shared,
compounded, deferrable options (like entering a new geographic market)
the impact of these value-drivers is just as large, but harder to trace.

This is because numerical real options analysis draws heavily on analogies
with financial instruments. Indeed, sometimes real options have an exact
value that NPV will never give you. But the less your real option looks
like a financial instrument, the harder it is to value.

Remember, though, that real options are not just about "getting a number".
The rigour of thinking about strategic decisions as real options can
help you make better decisions. Isn't this rigour just best-practice,
decision-tree NPV analysis? No, not really.

Real options focus on "dynamic complexity": the evolution of a few
complex factors over time that determine the value of investment and
cash flows. These are factors about which decisions can be taken at
any time over a period.

Decision-tree analysis tends to consider great detail in the cash flow
models and many uncertainties, but relatively little in the way of dynamic
decision making; "detail complexity" if you like. There are a large
number of these factors with decisions made at discrete time periods.

It would be foolish to argue that "dynamic complexity" is generally
more important than "detail complexity". Just as it would be foolish
to argue that real options are anything but a complement to best-practice
NPV. But real options can distil your strategic thinking into focussing
on a few, key dynamic processes, where a decision-tree would overflow
the largest boardroom whiteboard. In this sense, they integrate these
two aspects of your investment decision making in one tractable framework.

To wrap up: valuing irreversible investment opportunities under uncertainty
using NPV does not take account of managerial options and treats capital
assets as passively held. A real options approach can help by valuing
these managerial intangibles and preventing mistakes. Valuing real options
borrows complex tools but don't let this obscure the simple intuition.
Where appropriate, real options will help you make better decisions.