Real options are an emerging field of financial engineering that in my opinion will completely replace net present value in the next 10 years. The reason is that net present value is a flawed model for evaluating projects. The problem is that managers who experience these decisions know that that approach is full of implied assumptions that are rigid or even wrong. For example, if you start a project and it turns out to be going badly, it will not last ten years but will be either abandoned or scaled down. Furthermore, if it is a successful project its life will either be extended or it will be scaled up. Finally, no one says that the initial investment has to take place right now, it could take place next year or the year after, which is a deferral option. All managers know that there are abandonment options, extension options, contraction options, expansion options and deferral options in every project. Experienced managers have all been in situations where they have taken the net present value numbers and basically thrown them away, because their intuition told them that flexibility will add value to the project. If you frame the issue in that way you therefore begin to realise that net present value is very limited.
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