The biggest challenges in applying it to projects are .
-analysing projects to determine the range of options that are available to management.
-modelling the interaction between technical options and financial ones.
-modelling the value of information that will become available in the future.
When a manager takes on a project he does not relax and allow it to follow a course of its own. He must make further decisions and instruct strategy each step of the way. According to Bealey and Myers (2001), when you use discounted cash flow to value a project, you implicitly imply that your firm will hold the project passively. In order words, you are ignoring the real options attached- options that sophisticated managers can take advantage of.
In a nutshell, real options analysis simply gives managers the benefit of keeping their options open. This is where flexibility comes into play:.
1. Timing option.
2. Expansion option.
3. Abandon option.
4. Switching option.
What is a real option.
In general, "a real option exists if we have the right to take a decision at one or more points in the future (e.g. To invest or not to invest, or to sell out or not to sell out). Between now and the time of decision, market conditions will change unpredictably, making one or other of the available decisions better for us, and we will have the right to take whatever decision will shut us best at the time (Howell, et al, 2001).
A temporary shut down or delaying a project on purpose is an option, which can create value. By exercising his option to wait, a manager can collect more information about market decisions, which might aid future decisions. An expansion option can be exercised if new information emerges on the market, which is favourable and suggests that investments should be increased. Abandonment options help decided when to terminate a project that is not working; shutting it down before it reaches its original expected life cycle end.