Traditional discounted cash flow (DCF) analysis�where a project�s cash flows

areestimated and then discounted to obtain an expected NPV�has been the cornerstone
of capital budgeting since the 1950s. However, in recent years, it has
beendemonstrated that DCF techniques do not always lead to proper capital budgeting
decisions. DCF techniques were originally developed to value securities such as
stocks and bonds. They are passive investments�once the investment has been made,
most investors have no influence over the cash flows that result. However, real
assets are not passive investments�managers often can take actions to alter the
cash flow stream even after the project is in operation. Such opportunities are
called real options��real� to distinguish them from financial options, such as an
option to buy shares of GE stock, and �options� because they provide the right but
not the obligation to take some future action. Real options are valuable, but
thatvalue is not captured by a traditional NPV analysis. Therefore, real options
must be considered separately.
There are several types of real options: (1) growth (or expansion), where the
project can be expanded if demand turns out to be stronger than expected;
(2) abandonment, where the project can be shut down if its cash flows are low;
(3) investment timing (or delay), where a project can be postponed until more
information about demand and/or costs is available; (4) output flexibility, where
the output can be changed if market conditions change; and (5) input flexibility,
where the inputs used in the production process (e.g., oil versus natural gas for
generating electricity) can be changed if input prices change.

Opportunities that are embedded in capital projects that enable managers to alter
their cash flows and risk in a way that affects acceptability (NPV)

In making capital budgeting decisions, we must consider some procedures such as (1)
estimate relevant cash flows, (2) apply an appropriate decision technique such as
NPV or IRR to those cash flows, and (3) recognize and adjust the decision technique
for project risk. Although these procedures were believed to yield good decisions,
a more strategic approach to these decisions has emerged in recent years.