A real option is an economically valuable right to make or else abandon some choice that is available to the managers of a company, often concerning business projects or investment opportunities. Real options can include the decision to expand, defer or wait, or abandon a project entirely.

Example 1: An industrialist who owns a factory with excess capacity has an option to increase production that she may exercise at any time. This option might be of particular value when demand for the factory's output increases.

Example 2: The owner of an oilfield has an option to drill for oil that he may exercise at any time. In fact since he can drill for oil in each time period he actually holds an entire series of options. On the other hand if he only holds a lease on the oilfield that expires on a specified date, then he holds only a finite number of drilling options.

Example 3: A company is considering to invest in a new technology. If we ignore the optionality in this investment, then it may have a negative NPV so that it does not appear to be worth pursuing. However, it may be the case that investing in this new technology affords the company the option to develop more advanced and profitable technology at a later date. As a result, the investment might ultimately be a positive NPV value project that is indeed worth pursuing.

Types of Real Options

Sizing options are options relating to the size of a project. Depending on the ROI analysis, options may exist to expand, contract, or expand and contract the project over time, given various contingencies.

Timing options relate to the lifetime of a project - to initiate one, delay starting one, abandon an existing one, or plan the sequencing of the project's steps.

Flexibility options involves the project's operations: the process flexibility, product mix, price setting, and operating scale, among others.

Fundamental Options treat an entire investment as an option. For example, an oil exploration company may choose not to drill any new wells if oil prices fall below a certain threshold. Research and development projects are often viewed as fundamental options.

There are four common approaches to evaluating capital projects with real options:

1. Using the NPV without considering options. If the NPV is positive, the firm goes ahead with the investment.

2. Using the formula: Project's NPV = NPV (based on discount cash flows alone) - Cost of options + Value of options

3. Using decision trees.

4. Using option pricing models.

Valuation techniques for real options do often appear similar to the pricing of financial options contracts, where the spot price or the current market price refers to the current net present value (NPV) of a project. The net present value is the cash flow that's expected as a result of the new project, but those flows are discounted by a rate that could otherwise be earned for doing nothing.

The precise value of real options can be difficult to establish or estimate. It's difficult to pin an exact financial value on benefits of a real option.