The most important decisions made by managers are those that commit resources to new projects. The initial selection from a variety of projects and subsequent choices for further investment are crucial. However, quantitative methods currently used to facilitate those types of decisions handicap them from the start. The classic Discounted Cash Flow (DCF) techniques, for example, tend to favor short-term, low-risk projects. The potential derived from uncertainty, the value of information that will become available, and the long-term are neglected and are often later inserted as part of a gut-level analysis by the manager.
Also debilitating is the lack of flexibility imposed by a methodology that does not take into account intermediate alternatives other than full investiture or divestiture. The Real Options approach provides both a conceptual framework and quantitative tool for addressing the obvious shortcomings of the current techniques for evaluating projects and making decisions. Analogous to financial options, Real Options introduce flexibility in the form of intermediate investment choices, such as staging investments, scaling operations, and switching projects.
Options thinking provides a repeatable method for standardized evaluations and justifiable quantitative support for decisions, so that “inertia” does not cause escalation of commitment in an unprofitable project.