Real Options in Business Projects

Decision Tree Approach

Saeyeul Park
Problems with Traditional NPV Analysis

Traditional NPV analysis ignores real options

embedded in business projects
- NPV analysis underestimates the true value of the
project
Three Types of Real Options

1. Option to expand

2. Option to abandon

3. Option to delay
Decision Tree Approach

We graphically show the alternatives

available to us in each time period

NPV adjusted for the value of real options is

the weighted average of all possible NPVs in
different scenarios
Decision Tree Approach

In the real world, we can learn by observing

what happens in the next time period and
adapting our behavior
1. Option to Expand

Year 0 1 2 3 4 5 6
CF -10M 2M 2M 2M 2M 2M 2M

Discount rate = 20%

Let’s calculate the NPV of this project

Considering the Uncertainty

Year 0 1 2 3 4 5 6
CF -10M 2M 2M 2M 2M 2M 2M

Discount rate = 20%

Year 0 1 2 3 4 5 6
CF1 -10M 5M 5M 5M 5M 5M 5M
CF2 -1M -1M -1M -1M -1M -1M

CF1 and CF2 have equal probabilities of occurring

(Prob1 = Prob2 = 50%)
Option to Expand

Year 0 1 2 3 4 5 6
CF1 -10M 5M 5M 5M 5M 5M 5M

CF2 -1M -1M -1M -1M -1M -1M

We can observe the outcome in Year 1

Option to Expand

Year 0 1 2 3 4 5 6
CF1 -10M 5M 5M 5M 5M 5M 5M
10M 10M 10M 10M 10M
CF2 -1M -1M -1M -1M -1M -1M

We can observe the outcome in Year 1

If Scenario 1 turns out to be correct, we would like to

expand!
Value of real option = NPV with option – NPV without option = 2.88 – (-3.35) = $6.23M
2. Option to Abandon

Managers also have the option to abandon

existing projects
2. Option to Abandon

Managers also have the option to abandon

existing projects

Year 0 1 2 3 4 5 6
CF1 -10M 5M 5M 5M 5M 5M 5M
CF2 -1M -1M -1M -1M -1M -1M

We can observe the outcome in Year 1

If Scenario 2 turns out to be correct, we would like to

abandon!
2. Option to Abandon

Managers also have the option to abandon

existing projects

Year 0 1 2 3 4 5 6
CF1 -10M 5M 5M 5M 5M 5M 5M
CF2 -1M -1M -1M -1M -1M -1M
-1M

We can observe the outcome in Year 1

If Scenario 2 turns out to be correct, we would like to

abandon!
Value of real option = NPV with option – NPV without option = (-2.10) – (-3.35) = $1.25M
3. Option to Delay

Option to delay also adds value to the project

Having a negative NPV today does not

necessarily mean that the project is a bad
one
- We do not undertake the project today, but
we will want to in the future if the project becomes
profitable
- Examples: oil industry, mining industry, …