Describe the real option approach to risk-adjusted capital budgeting.

Describe the real option approach to risk-adjusted capital budgeting.

What will be an ideal response?

ANSWER

Real options involve the contractional ability to make changes in capital projects, particularly once they are underway. Such options involve the ability to alter outputs (expand, contract, shutdown), alter inputs (both input types and processes using them), and postpone or abandon projects. These options give the holder the right, but not the obligation, to exercise them and usually require the holder to pay an extra amount for this privilege. To determine whether such options are worthwhile, one would calculate the difference in the expected net present values of the capital projects with and without the option and compare it to the cost of paying for the option.