The value of management flexibility—a real option approach to investment evaluation

Abstract Traditional project evaluation based on discounted cash flow analysis ignores the upside potentials to an investment from managerial flexibility and innovations. A real option approach that borrows ideas from financial options offers a fresh perspective. It views investment strategy as being crafted as a series of options that are continually being exercised to achieve both short and long term returns on investment. Management's flexibility to adapt to changes in technology and market introduces a skewness in the distribution of investment payoffs with improved upside potentials. This paper critically reviews the fundamental differences in assumptions between the traditionally passive approach and the active real options model. The roles of various real options in expanding bandwidth of opportunity, technology investment and business acquisition decision as real options are discussed and illustrated.