An Investment Criterion Incorporating Real Options

Abstract: This paper provides an investment decisionmaking criterion under uncertainty using real options methodology to evaluate if an investment should be made immediately, cautiously, deferred (wait-and-watch), or foregone. We develop a decision-making index d, which is equal to the expectation of net present value (NPV) normalized by its standard deviation. Under a lognormal assumption of the distribution of NPV discounted by riskfree rate, we find the “break-even point” at which the NPV equals the real option value (ROV): d = D = 0.276. Using the absolute value of D, one can make sophisticated decisions considering opportunity losses and costs of uncertainty. This new decision index, d, provides a criterion to make investment decisions under uncertainty. When making a decision, a manager only has to observe three parameters: expectation of future cash flow, its uncertainty as measured by its standard deviation, and the magnitude of investment. We discuss examples using this criterion and show its value. The criterion is particularly useful when NPV lies near zero or uncertainty is large.