The development of a major marine oil field done by either building platform of specified capacity or implement variable capacity.

"Real options" can also physically build into projects and products, giving options - and the capability to improve performance - otherwise not present.
For example: -

Building power plants to use several types of fuel, for example, oil or natural gas. This flexibility costs money, but provides the potentially valuable option to switch from one source of supply to another according to relative fuel prices.

Inadequacy of Traditional Valuation Methods for Risky Projects

Traditional methods for project valuation (variants on net present value or discounted cash flow analysis) focus on a single stream of income and expenses .The assumption of single cash flow and value of this average cash flow equals the average value of a range of cash flows is false whenever the probability distribution of the returns is asymmetric, as is typically the case. Running multiple analyses for different cash flows, and then averaging the results according to the estimated probabilities might overcome this difficulty. However, this is not done in practice, and does not adequately address financial risks.

They also assume that initiation of a project entails a complete commitment to the cash flow specified, implementation always occurs, even when the early results are not promising. Moreover, they do not provide flexibility or any alternative.

Most projects involve options. Figure 1 illustrates this as a simple, two-stage decision tree. The first decision is about starting a project; the later choice is about completing development. In between these choices, the managers can observe the resolution of uncertainties, such as the success of the initial research.

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* Contributed by -
Jyoti Singh,
PGDBM 2006,
IMT, Ghaziabad.