This chapter uses and extends the lessons learned in chapters 20 and 21 to evaluate the real options of different types, which are often encountered by the corporate financial manager. Real options can be very valuable and can add value to the firm, if they are understood correctly and acted upon. Chapter 10 provided a brief introduction to the four common real options typically found in many capital investment projects. These are:

• The option to expand and make follow-on investments.
• The option to abandon or shrink a project.
• The option to wait and learn before investing.
• The option to change the input, the output or the production methods.

These options need to be considered as part of the capital investment project and included in the value of the project. The chapter provides a number of examples of valuing these options using the Black-Scholes or the binomial method. The options approach to valuation of these special situations associated with capital budgeting decisions is necessitated by the fact that simple discounted cash flow (DCF) analysis does not work very well in these cases. The DCF analysis is designed for analyzing investments, which do not change their nature during the life of the project. It is ideally suited for evaluating passive investments like bonds and stocks. Most corporate assets or investment projects are, on the other hand, actively managed by the manager. Projects can very often change their nature in terms of risk, cost structure, and expansion or abandonment possibilities. A smart manager will respond appropriately to these changes. These situations are best valued as options, which permit multiple decision points. The additional rounds of decisions give the manager more choices and enable the firm to capitalize on good fortune or to mitigate losses. The choices create uncertainty, which often makes the option more valuable.