In addition, competitors might have real options as well that needs to be taken into account when the economic rent of the project is assessed. Real options are often complex and have lack of a formal structure, which makes it difficult to estimate cash flows. Option pricing models can help to value the real options in capital investment decisions, but when we price options we rely on the trick, where we construct an option equivalent of the underlying asset and a bank loan. Practical problems in valuing real options Airlines and shipping lines can switch capacity from one route to another. In agriculture, a beef producer will value the option to switch between various feed sources to use the cheapest alternative.

Flexible production options are in particular valuable within industries where the lead time (time between an order and delivery) can extend for years. Such options are known as flexible production options. Natural resource companies Flexible production optionДЇirms often have an option to vary inputs to the production or change the output from production. Airlines routinely close routes where the demand is insufficient to make the connection profitable. Abandonment options can usually be evaluated using the binominal method. An option to abandon a project is valuable: If bad news arrives you will exercise the option to abandon the project if the value recovered from the project's assets is greater than the present value of continuing the project. However, in reality firms may have the option to cease a project during its life. Traditional capital budgeting assumes that a project will operate in each year during its lifetime. The decision when to harvest a forest Abandonment option The optimal timing is a trade-off between cash flows today and cash flows in the future. In particular if we can delay the investment decision we have an option to wait. Timing optionДЄn investment opportunity with positive NPV does not mean that we should go ahead today. Building 6-lane bridges when building a 4-lane highway. A pharmaceutical company acquiring a patent that gives the right, but not the obligation to market a new drug. Provide extra land and space for a second production line when designing a production facility.

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