As the name suggests, real options have investments in real assets, not financial securities such as stocks and bonds, as their underlying values. Real options analysis is aimed at the valuation of such investments using the option pricing techniques discussed in the previous chapters. Real options analysis is a comparatively new area in finance: the term real options was coined in 1977 by Stewart Myers. But publications on the topic did not appear in significant numbers until the mid 1980s, ten years after the publication of the Black and Scholes model. Real options analysis is rapidly gaining importance and some even predict that it will replace NPV as the central paradigm for investment decisions [Copeland and Antikarov, 2001, p. VI]. As we shall see, real options analysis overcomes the weakness of NPV in valuing flexible projects. The Black and Scholes formula and its descendants allow us to calculate the value of flexibility, that is difficult to price with traditional discounted cash flow methods.

Investment opportunities as options

Before we turn to the valuation of real options, we shall first explore the similarities and differences between real and financial options and investigate what the sources of real option value are.