The introduction of option pricing theory (OPT) has been well received by practitioners, who have struggled with discounted cash flow (DCF) analysis for many years.1 The ability of option pricing theory to quantify flexibility in strategic investment projects makes it a very appealing choice. This is especially so when one considers the fact that flexibility is often not explicitly taken into account by standard DCF analysis. Incorporating the value of flexibility could increase the total value of the project and may increase the probability of acceptance, an incentive for practitioners to try OPT in capital budgeting. The value of flexibility of an investment project is basically a collection of real options, which can be priced with the techniques known from financial options. Despite this incentive, the process of adapting OPT to the practice of strategic decision-making is far from smooth. In most cases, the introduction of OPT would require practitioners to fundamentally reconsider their standard capital budgeting techniques. And when all this hard work has been done, there is still the question: how do we tell management? That question seems to lead us back to where we started. For practical purposes, we cannot afford to come up with very complicated options techniques that can only be priced with black-box computer programs.2 The contribution of real options in practice is limited when one cannot explain what the important options are and why DCF analysis cannot be used. In this paper, the major insights gained from practical case applications, developed in cooperation with the group planning and manufacturing functions in Shell's central offices and a number of Shell operating companies, are presented.3 Shell's main interest was to conduct a number of exploratory studies on the use of OPT in capital budgeting decisions. The studies are part of a group planning program to adapt existing and develop new techniques for strategic decision-making. In practice, real world cases have to be simplified in order to keep the analysis tractable. This applies for the OPT as well as for a standard DCF analysis. During an initial round of discussions, a number of investment opportunities were selected which were of particular interest to Shell and appeared to be illustrative of the potential benefit of applying OPT in capital budgeting decisions. Three of these cases are described here in some detail. Each case follows the same format. It begins with a problem and model description, followed by the presentation of the data and results. The depth of analysis differs from case to case. Sometimes more attention is paid to the model description, and sometimes more time is spent on data estimation. Since all cases are confidential, the data have been disguised and some details have been omitted, without changing the basic option-like characteristics of the decision problem. The paper is organized as follows: Section I analyzes the timing option in an offshore project. In Section II, a so-called growth or sequential option case is presented, where the introduction of OPT helped management to reformulate their investment proposal. Section III contains an abandonment decision of a refinery production unit. In Section IV, the important steps of the decisionmaking process, when options are involved, are presented. This is followed by a summary of the major insights gained by the practitioners involved. Finally, the conclusion discusses the major contributions of real options in practice.
