Business and Personal Finance Dictionary

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• REAL OPTION
  
  Definition: An option that involves tangible objects – such as bricks and mortar, pipelines and equipment – rather than financial instruments and cash flows, and physical actions – such as excavation, construction, demolition, physical movement, and hard work – rather than simply tendering notice of the exercise of an option. Examples: Examples include the following decisions to: - build a plant today, rather than wait until next year - choose a more flexible and more expensive production process, rather than a cheaper one with fewer applications - decline a marriage proposal and play the field, looking for a better proposal - go for an MBA, rather than a law degree Applications: The main business application for real options seems to be capital budgeting, i.e., business investment. The idea is that one investment may open doors to other opportunities that may grow or not, and that traditional net present value methods are not up to the task of evaluating such investments. Comment: Although the real option approach is theoretically sound, the challenge of applying it correctly to get out a useful value is daunting. I have waited 30 years to see widespread use of the capital asset pricing model for capital budgeting. We may have to wait as long to see widespread use of real option theory.
  
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