In finance two different interpretations for options exist:
* [[Financial Options]] as found in the financial markets
* [[Real Options]] which are an attempt to apply similar concepts to entrepreneurial project and financial decisions.

When mapping project characteristics onto call option variables you can see the following similarities:
|Project|Variable|Option|h
|Expenditures required to acquire the asset|''$X$''|Exercise price|
|Value of the operating assets to be acquired|$S$|Stock price|
|Length of the time decision may be defered|$t$|Time to experation|
|Riskiness of the underlying operating assets|$\sigma ^2$|Variance of returns on stock|
|[[Time value of money]]|$r$|[[Risk free rate of return]]|

When a decision cannot be delayed standard [[DCF]] techniques as [[NPV]] or NPV_q are sufficient to model the decision. However if the decision //''can''// be delayed, the project is more like an option and also will need to take the riskiness of the project into account.

A very simple summary of using real options as an approach for investment decisions is:
* Use [[DCF]], [[NPV]] or [[IRR]] in most cases.
* Only for projects for which have very good data and estimates of how risk accummulates over time a real option approach may be applicable.

The riskiness is represented by the remaining option variable $\large \sigma$. The variability, per unit time, of the project is represented by the variance of the returns, $\large \sigma ^2$. Cumulative variance is a measure of how things could change over time and represented as $\large \sigma ^2 t$

<<image /static/files/MBI/Module%2013/npvqgraph.png width:700>>

bag
finance_public
created
Sat, 04 Jun 2011 20:23:22 GMT
creator
dirkjan
modified
Sat, 04 Jun 2011 20:23:22 GMT
modifier
dirkjan
tags
Capital projects as real options
creator
dirkjan