Question

when making a capital budgeting decision suppose you do not take into consideration a real option inherent in a project. what error might result?

Answer 1

A) As NPV is the major concept in which we believe to make the decisions , real options extends the NPV approach. It is important because sometimes NPV is not enough to capture the complex nature of projects. For example NPV doesnot capture non linear nature of cash flow and changing risk profiles of the project.There are various types of real options such as timing options, growth options, abandoment options, flexibility options, and fundamental options.( While making a decision when there is option, we have to consider cost of the option vs value of the option)

Real option NPV= Traditional NPV+ Real option value

Conclusion

Real options helps managers in making strategic investment decisions. Especially for compex projects they are more meaningful than NPV. They also informs about the timing of project (When to take and when to differ a project) and add more flexibility to managers.

So if we do not consider real options inherent in project, we may take project in a wrong time (Real options capture timing better). And in some complex cases we might take wrong decision (As NPV doesnt capture all information). So its better to consider option for better (informed) decision making than traditional NPV.