The General Flexibility to Switch: Real Options Revisited

We present a simple analysis of the generic flexibility to switch between alternative technologies or operating "modes." The firm can select between alternative projects based on inflexible (rigid) technologies, or a flexible project that allows for switching the operating mode, possibly at some cost. Without switching costs, the value of the flexible project can be seen as the value of a rigid project plus the sum of the values of the options to switch in future periods. The presence of switching costs, however, creates a compoundness effect that may make option value additivity break down. The resulting decision rule reflects a persistence or hysteresis effect where, even though immediate switching may seem attractive, it may be long-term optimal to wait. This general framework subsumes as special cases most other known real options. The option to defer investments, expand or contract production, temporarily shut down and restart operations, abandon for salvage, and default during construction are revisited. The framework also finds applications in flexible manufacturing systems and other capital investments.