Taking on new projects opens doors to new opportunities. Those opportunities have a value that can be analyzed using option pricing models. When we are valuing new enterprises, startups, or projects, we may not be adequately capturing this in our valuations.
Projects that expand the set of opportunities have positive option values. And conversely shutting down a project limits the set of opportunities going forward and has a negative option value.
A project’s impact on the firm’s opportunities, or its option value, may not be captured by conventional NPV analysis.
The Black-Scholes Option Pricing Model is the most famous formula and a straight forward way to price options.
The oil company Anadarko famously employed this new analytical method in 1994 to value oil field prospects and made winning bids in Gulf leases.
The new economy is filled with rapid change and uncertainty and real option valuation helps more accurately price those risks and opportunities.
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