Challenges to the practical implementation of modeling and valuing real options

Abstract

A great deal of theoretical work exists on how to model and value investment opportunities having real options. To date, this work has provided new insights into capital budgeting decision-making and a new decision-making framework. However, the currently proposed real option models are not widely used by corporate managers and practitioners. The question is, "Why not?" This paper posits one possible answer to that question. Specifically, this paper reviews what has been accomplished in modeling and valuing real options and examines practical implementation problems associated with the real option approach. The issues examined are: (1) The types of models currently used are not well known or understood by corporate managers and practitioners; (2) The required modeling assumptions are often violated in a practical real option application; and (3) The necessary additional assumptions required for mathematical tractability limit the scope of applicability. We then discuss possible alternatives for modeling and valuing real options that capture the essence of the problem, but do so in a simpler framework. This paper demonstrates the need to identify and develop alternative frameworks for practically modeling and valuing real options.