The option valuation recognizes the value of learning. This is important, because strategic decisions are rarely one-time events, particularly in investment-intensive industrial sectors. NPV, which does not properly recognize the value of learning more before a full commitment is made, is for that reason often inadequate. In fact, its inadequacy can be stated in the precise terms of the real-options model. Of the six variables in that model, NPV analysis recognizes only two: the present value of expected cash flows and the present value of fixed costs. The greater comprehensiveness of option valuation can therefore be summed up in this way: it captures NPV plus flexibility value – effectively, the expected value of the change in NPV over the option’s life.
Authors: Keith Leslie, Max P. Michaels
Source: “McKinsey Quarterly”
Subjects: Finance, Management
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