REAL OPTIONS AND INTERACTIONS WITH FINANCIAL FLEXIBILITY

Many academics and practicing managers now recognize that the net present value (NPV) rule and other discounted cash flow (DCF) approaches to capital budgeting are inadequate in that they cannot properly capture management's flexibility to adapt and revise later decisions in response to unexpected market developments. Traditional NPV makes implicit assumptions concerning an ''expected scenario'' of cash flows and presumes management's passive commitment to a certain ''operating strategy'' (e.g., to initiate the project immediately, and operate it continuously at base scale until the end of its prespecified expected useful life). In the actual marketplace, characterized by change, uncertainty and competitive interactions, however, the realization of cash flows will probably differ from what management expected initially. As new information arrives and uncertainty about market conditions and future cash flows is gradually resolved, management may have valuable flexibility to alter its operating strategy in order to capitalize on favorable future opportunities or mitigate losses. For example, management may be able to defer, expand, contract, abandon, or otherwise alter a project at different stages during its useful operating life. Management's flexibility to adapt its future actions in response to altered future market conditions expands an investment opportunity's value by improving its upside potential while limiting downside losses relative to management's initial expectations under passive management. The resulting asymmetry caused by managerial adaptability calls for an ''expanded NPV'' rule reflecting both value components: the traditional (static or passive) NPV of direct cash flows, and the option value of operating and strategic adaptability. This does not mean that traditional NPV should be scrapped, but rather should be seen as a crucial and necessary input to an options-based, expanded NPV analysis, i.e.,