Real options theory in comparision to other project evaluation techniques

Abstract

Wrong investment decisions today can lead to situations in the future that will be unsustainable and lead eventually to the bankruptcy of enterprises. Therefore, good financial management combined with good capital investment decision-making are critical to survival and long-term success of the firms. Traditionally, the net present value (NPV) and discounted cash flow (DCF) methods are worldwide used to evaluate project investments. These techniques have been classified in two major groups: sophisticated and non-sophisticated. In the former group, techniques like the DCF methods (e.g. NPV and IRR) can be found. In the latter group, techniques like the Payback Period and the Accounting Rate of Return have been included. However given that, today investments are characterized by high risks and uncertainty, DCF methodologies are inadequate to deal with these issues. Some authors argue that only the techniques that can appropriately address the problem of uncertainty (like the Real Options theory) should be applied. In this paper, the major differences between DCF methods and Real Options (RO) theory will be analyzed. Using an example, the advantages of the RO theory, compared with other methods, such as the DCF methods, in the search of better decisions will be shown. This work is expected to contribute to an increase of application of the RO Theory, by showing this technique potential.