Real Options Theory

The concept and the limits of NPV

Traditional investment appraisal discounts future cash flows and invests if net present value is positive. This rule implicitly assumes that an investment is now or never and cannot be changed once made. Stewart Myers (1977) observed that much of a firm's value comes not from assets in place but from future growth opportunities, which, like financial options, are rights exercised only when conditions are favorable, and he coined the term real options. When uncertainty is high, bad outcomes can be avoided by not exercising while good outcomes are captured, so option value actually rises. Relying on NPV alone can therefore undervalue promising projects.

Types of options and irreversible investment

Real options include the option to defer the timing of investment, to expand scale after success, to abandon if conditions deteriorate, to switch production methods and to stage investment step by step. Brennan and Schwartz (1985) valued options to shut down and reopen a mine, and McDonald and Siegel (1986) showed that the value of waiting can be large when deciding when to make an irreversible investment. Bernanke (1983) argued that under high uncertainty firms postpone investment while waiting for information, which can amplify business cycles. Pindyck (1991) and Dixit and Pindyck (1994) synthesized this work, systematizing the conclusion that with irreversible investment it is optimal to invest only when expected returns exceed costs by a substantial margin. Majd and Pindyck (1987) analyzed sequential options in investments with long construction times.

Extensions to strategy and macroeconomics

Trigeorgis (1996) framed managerial flexibility and strategy in the language of options. Kogut (1991) interpreted joint ventures as options to expand by later acquiring the partner's stake, and Bowman and Hurry (1993) used an option lens to analyze how firms probe opportunities with small investments before committing incrementally. This perspective is used alongside dynamic capabilities and the resource-based view in research on strategy under uncertainty. Grenadier (2002) extended it to games in which competing firms take each other's exercise decisions into account. In macroeconomics, Bloom (2009) showed empirically that uncertainty shocks cause firms to pause investment and hiring temporarily, a wait-and-see effect, so real options logic also informs business cycle research. Limitations include the difficulty of estimating volatility for untraded real assets and the fact that options may be shared with competitors.

FAQ

What is real options theory in simple terms?

It treats an investment opportunity not as an obligation to act now but as a right to act later, scale up or walk away as events unfold, and puts a value on that flexibility.

Why does higher uncertainty raise option value?

Because bad outcomes can be avoided by not exercising the option, losses are limited while the upside from good outcomes can grow.

Sources reviewed: 2026-10-26

References

1. Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147–175.
2. Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81(3), 637–654.
3. Brennan, M. J., & Schwartz, E. S. (1985). Evaluating natural resource investments. Journal of Business, 58(2), 135–157.
4. McDonald, R., & Siegel, D. (1986). The value of waiting to invest. Quarterly Journal of Economics, 101(4), 707–727.
5. Majd, S., & Pindyck, R. S. (1987). Time to build, option value, and investment decisions. Journal of Financial Economics, 18(1), 7–27.
6. Bernanke, B. S. (1983). Irreversibility, uncertainty, and cyclical investment. Quarterly Journal of Economics, 98(1), 85–106.
7. Pindyck, R. S. (1991). Irreversibility, uncertainty, and investment. Journal of Economic Literature, 29(3), 1110–1148.
8. Dixit, A. K., & Pindyck, R. S. (1994). Investment under Uncertainty. Princeton: Princeton University Press.
9. Trigeorgis, L. (1996). Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge, MA: MIT Press.
10. Kogut, B. (1991). Joint ventures and the option to expand and acquire. Management Science, 37(1), 19–33.
11. Bowman, E. H., & Hurry, D. (1993). Strategy through the option lens: An integrated view of resource investments and the incremental-choice process. Academy of Management Review, 18(4), 760–782.
12. Grenadier, S. R. (2002). Option exercise games: An application to the equilibrium investment strategies of firms. Review of Financial Studies, 15(3), 691–721.
13. Bloom, N. (2009). The impact of uncertainty shocks. Econometrica, 77(3), 623–685.