Chapter 23: Real Options in Capital Budgeting

The authors detail the "option to expand," using the example of Blitzen Computers to demonstrate how an initial negative-NPV project can be financially viable when viewed as a call option that purchases the right to pursue highly profitable follow-on investments. The summary explains how these non-traded real assets are valued using financial option pricing models, specifically the Black-Scholes formula and binomial trees, by mapping project characteristics—such as the present value of cash flows and investment costs—to stock price and exercise price parameters. A significant portion of the chapter is dedicated to the "timing option," or the option to wait, which illustrates that committing immediately to a positive-NPV project may be suboptimal if delaying allows the firm to resolve market uncertainty, a concept parallel to an American call option on a non-dividend-paying stock. This is exemplified through decision scenarios involving a "malted herring" factory and real estate development, where the value of "wait and see" often exceeds the value of immediate execution. The text also examines the "option to abandon," effectively a put option that allows a firm to exit a project and recover salvage value if cash flows deteriorate, using the "Perpetual Crusher" project to show how abandonment value serves as insurance against downside risk. The concept of temporary abandonment is further explored through the example of mothballing an oil tanker, which involves complex hysteresis where reactivation thresholds depend on volatility and transition costs. Additionally, the chapter covers "flexible production options," such as combustion-turbine power plants that profit from the "spark spread" between electricity and gas prices, and aircraft purchase options that allow airlines to manage fleet capacity amidst demand uncertainty. Finally, the summary addresses the practical application of these theories, discussing the validity of risk-neutral valuation for non-traded assets, the impact of taxes on discount rates, and the strategic implications of growth options, which act as off-balance-sheet leverage and require careful consideration of competitive interactions and game theory.