Real options analysis as a practical tool for capital budgeting

Purpose – This paper aims to demonstrate the practical application of real options analysis to the evaluation of multistage projects, using an example involving a commercial real estate development. Design/methodology/approach – The approach demonstrated builds on static discounted cash flow (DCF) analysis and requires knowledge of only the binomial option pricing model. Findings – Real options analysis can be implemented in a spreadsheet and only one parameter – the volatility of the price of the completed project – needs to be estimated in addition to those required for static DCF analysis. The approach described can be used to evaluate a project at any stage of development, which is especially useful when the suspension of partly completed projects is under consideration. Originality/value – The paper shows how to carry out real options analysis of complex multistage development projects using straightforward valuation tools, making an important project evaluation technique more readily available to practitioners.