DECISION MAKING AND VALUATION OF PROJECTS: REAL OPTIONS


Ekici O.

in: Management & Strategy, Gözde Mert, Editor, Artikel Akademi, İstanbul, pp.285-302, 2020

  • Publication Type: Book Chapter / Chapter Research Book
  • Publication Date: 2020
  • Publisher: Artikel Akademi
  • City: İstanbul
  • Page Numbers: pp.285-302
  • Editors: Gözde Mert, Editor
  • Istanbul University Affiliated: Yes

Abstract

In this chapter of the book, we present project appraisal that typifies the top decision-making issues in management and strategy and discuss real options and the numerical methods in their analysis. Cash flows in projects or the future values of potential investments are unstable and bear uncertainties. This is why it is quite difficult to estimate the value of option and often hard to make decision using that value.

 

Institutions typically make decisions based on some financial indicators in evaluating an investment project; it may or may not be of an R&D type. Organizations conventionally use techniques like Net Present Value (NPV) and Internal Rate of Returns (Tatsiopoulos & Tolis, 2002; Ryan & Ryan, 2002; Remer & Nieto, 1995). Real option approach in valuation is relatively up to date. The method offers decision alternatives as to abandon, defer, switch, scale up/down, contract (Dixit & Pyndick, 1994; Copeland et al., 1990). Besides these flexibilities, real options provide reliable outcomes for long-term investment projects with uncertainty (Yeo & Qiu, 2003, Sorsimo, 2015).

 

In real option analysis, both analytical and numerical methods can be used to quantify the value of an investment opportunity. Numerical methods solutions, which are currently under rapid development, improve the decision processes as well (Bashiri et al., 2018). Thus, they enrich the assessments and allow for decision-making models in strategic management.   

 

In this study, attention is paid mainly to Monte Carlo simulation technique for real options analysis and two hypothetical examples are produced either to illustrate various approaches and compare their outcomes or to elucidate numerical methods. Numerical methods have the advantages in complex or impractical analytical forms, however they may have accuracy problem for short execution times, which can be improved by some solutions. In the final section, a discussion on the solutions to value real options and the prominence of R&D type projects are given.