Can real-options analysis improve decision-making? Promises and pitfalls

Abstract

Executive Overview Managers are faced with uncertainty in nearly every aspect of their decisions. Reducing uncertainty, then, often leads to better decisions and greater potential firm success. The real-options literature provides one tool to reduce uncertainty. A real option is commonly defined as any decision that creates the right, but not the obligation, to pursue a subsequent decision. Used effectively, these options can minimize losses while preserving potential gains. Real options are used both formally, as a modeling tool for specific decisions, and informally, as a perspective for framing decisions in a different light. We separate real options into four distinct types—immediate entry, immediate exit, delayed entry, and delayed exit. We then provide additional understanding into how they differ and how each can reduce uncertainty. We also suggest that firms should use all four types of real options to search for additional benefits beyond uncertainty reduction. We identify several pitfalls to avo...