Making decisions under uncertainty using Real Option Analysis

Abstract

Valuing a project based on net present value does not easily capture the flexibility that the project offers and therefore undervalues and restrains that project. Real Options, based on financial option valuation, can capture this flexibility more efficiently and give the project manager the opportunity to alter the project when new information comes to life. The flexibility comes in the form of options, such as the option to defer, abandon, expand or default on a project.The purpose of this thesis is to find the required knowledge needed, to use Real Options and to show the importance of valuing flexibility in projects, by using a case study and going through the process of solving it using Real Option Analysis (ROA). As a result, the advantages of using this method becomes clear.The potential of Real Options arises with increased uncertainty and risks of a project. When a project has a negative net present value, or is not considered profitable, the usage of Real Options reaches its maximum capacity. Using the Real Options Analysis could alter the estimations on profitability and therefore the analysis should be done prior to execution of a project or in the planning phase. The knowledge needed to use for this methodology is summed up in three categories: Mathematical-, analytical- and ROA knowledge.Project managers who want to be able to value a project should examine the methodology of Real Options, either for the calculations or for the mindset, since flexibility of a project is a valuable asset which could alter the decision making in a situation of high uncertainty and risk.Keywords and phrases: Project management, risk management, uncertainty, Real Options, binomial option pricing.