The last scenario is that a project needs a contingency plan to make a change and no other analysis would be better than real option analysis to identify future opportunity values. The fourth scenario is to say that the uncertainty is too large to be ignored and the real option analysis can provide the correct value for the investment flexibility of a project. If there is not enough information to quantify the future beneficial values now, real option analysis will suggest the “waiting” option is better than regretting an irreversible investment decision. The third circumstance is focusing on waiting for more information on a favorable situation. Real option analysis can quantify these future or strategic values. Again, this is to focus on future or strategic values for a specified period of time. In other words, the future growth value is better than today’s benefits. The second scenario means the value of future growth opportunities is larger than the current cash flow. This scenario to apply the real options is where a decision maker has already understood the project will be altered before it starts. If a project needs to be upgraded during its lifetime, real option analysis would be a useful tool to analyze the strategic value for a project.
Strategy corrections mean selecting different choices. As we have indicated before, a strategy is all about choices. The first scenario is fairly self-explanatory. No other approach can correctly estimate this type of opportunity. When there is a contingent investment decision. Only the real option approach can correctly value investment flexibility. When uncertainty is large enough to make flexibility a consideration. When the outlook is so uncertain and it is sensible to wait for more information so that a decision maker can avoid regret for an irreversible investment decision that must be made now. When the NPV value should be captured by the possibility of future growth options. When a project needs updates and mid-course strategy corrections.
Can the real option theory be applied for any project under any investment circumstance? The simple answer would be “no.” Martha Amram and Nalin Kulatilaka provided five different scenarios when real option theory can be applied:
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