Any time a firm has the ability to make choices, there is value added to the project in question – Traditional NPV analysis ignores this value. The study of real options attempts to put a dollar value on the ability to make choices. What are real options and how are they valued.

Real options are the decision rights that a firm has when there is uncertainty surrounding their project. They allow for flexibility and creativity to be used in order to maximize value, as opposed to traditional NPV analysis which only takes into account expected future cash flows. Real options can include decisions like whether or not to invest in a project, timing of an investment, expanding or contracting an operation after initial implementation, and abandoning a project altogether if it proves too costly.

Valuing real options requires considering two factors: the option’s cost and its potential payoff. The cost is determined by looking at the sunk costs required to make certain decisions – such as those related to researching new projects or technologies – while the potential payoffs are based on how much additional value will be gained from making these decisions. Additionally, other variables such as market conditions and risk tolerance must also be taken into account in order to calculate an accurate value for a given firm’s real options.

Overall, understanding how real options work and how they are valued can help businesses make more informed decisions about investing their resources into uncertain projects with potentially high rewards but also some inherent risks involved.