Real Option Approach for Investment Project Evaluation

Discounted cash flow (DCF) is a traditional evaluating method for investment projects (IP). However, while making decisions on IP, DCF takes into consideration neither flexibility nor uncertainty factors (Dezen, Morooka, 2002). Castro and Schoizer state that the ROA could serve as a DCF traditional method replacement (Castro, Schiozer 2000). But why should we pay attention to flexibility in decision-making? Although management flexibility is one of the one of the key aspects in project management (PM), it is overlooked by companies (Castro, Loir 2019). Instead of being a competitive advantage, flexibility becomes a problem, a company weakness (Castro, Loir 2019). Many theorists declare the ROA to be quite efficient in IP evaluation. In practice, however, this method is hardly used because of its complexity. A 1997 Bain & Co. study of 475 global corporations found that 46% of those who experimented with real options abandoned this venture because of the small returns compared to the complexity of the calculations (Roche, 2008). It turns out that there are certain difficulties in applying the real options method during evaluating investment projects that decision makers do not want to face. The identification of these difficulties will be the basis of my work. I will try to review the project from the point of view of this methodology, evaluate the option that is in the project, and also understand how difficult it is to apply this methodology in practice. It should be noted at once that this study does not claim to be a very accurate analysis of the investment project. The methodology of real options is a rather complex and time-consuming tool. The Black-Scholes model, which will be used in this paper in conjunction with the construction of a binomial tree, is criticized by many researchers. The latter point to its inaccuracy, noting that this model can not give critically accurate results. However, this work will be another brick to build an understanding of the methodology of real options. Right now, the uncertainty factor is a significant problem for many large corporations. The COVID-19 pandemic was an excellent example of businesses not being prepared for uncertainty. Many companies closed because they could not deal with the effects of an unpredictable pandemic. After all, many companies turned toward dealing with the uncertainty factor and rethinking their old business systems. Unfortunately, many decision-makers now do not know how to deal competently with uncertainty. Besides, many managers factor uncertainty only in a negative way. However, from a theoretical point of view, the uncertainty factor, if handled correctly, can bring financially and strategic benefit to the company.