In almost every investment project, real options can be created or preserved. These options add value to a project (although they cost money) because they add flexibility to the project which makes managing the project easier. With this flexibility it is possible to pursue the project goals despite the uncertainty in the project. When the initial project plan and business case are ready it is time to consider the real options that can be created or preserved within the business case. These options can then be evaluated in different scenarios by decision tree analysis in order to determine their value. Subsequently the value adding real options should be documented and preserved by the project management in order to be able to effectuate these options in the project’s business case.

1. SIG Special Interest Group section project management
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Westport, pp. 1-9. ship: on the edge of project and process management. Insights
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edition, John Wiley, New York. trix: coping projects with ill defined goals and/or methods to
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tion. Harvard Business School Press, Boston, Massachusetts.
SIG Special Interest Group section business cases and project finance
How Real Options
add the Value of Flexibility
to your Business Case
Large investment projects often experience problems when
negative unforeseen conditions occur, such as the decrease
of demand for the product or service. The initial investment
decision for a project is often based on only one scenario.
This approach considers each investment decision as static;
results are not affected by changes occurring during the
different phases of the projects life cycle.
When conditions change, projects may come to a halt or experience long delays. By valuing
the real options of a project beforehand we may be able to mitigate the effects of these
unexpected events. Real options management make it possible to reach project success
under various circumstances. Project managers are able to make use of the flexibility
within the project to adapt the project to the specific actual circumstances. Real options
Joost van Blokland, are the options a project has to adjust the project to the outcome of uncertainties identified
SIG Business Cases and Project Finance Secretary at the start of the project. By valuing these real options the initial investment decision
is taken based on more than one scenario. The management of the project and its real op-
tions therefore becomes dynamic instead of static. Adding possibilities to abandon, defer,
advance, expand, contract, switch or divide a project, i.e. adding flexibility, to a project
faced with uncertainty will make it better equipped to weather the storm of uncertainty.
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2. SIG Special Interest Group section business cases and project finance
What are options? money to execute. In fact it could be prohibitively expen-
An option is a predetermined right, but not the obligation, sive for an authority to pay upfront for the right to termi-
to buy (call) or sell (put) assets against a predetermined nate a contract.
price (strike price) at a certain moment or during a certain Real options can have different effects on an investment
period. These rights are captured in option contracts. project. The most common real options in large invest-
The option buyer pays a so-called premium to the seller ment projects are:
in return for granting him the right to buy or sell the • exit options: to abandon the project;
asset at that fixed price. The asset is referred to as the • timing options: to defer or advance the project;
underlying value of the option. • size options: to expand or contract the project;
• flexibility options: to switch the content of the project;
The difference between financial options and real options • compound options: to divide the project into different
The most common options are those on the financial options.
market; options are often mentioned when people talk of
Wall Street. Options on the financial market are written A real option in real life:
on financial assets like stocks, currencies and commodities. A2 Amsterdam - Utrecht highway
The value of the asset on which the option is written is In 2006 the Dutch Minister of Transport, Public Works
referred to as the underlying value of the option. In case and Water Management decided to broaden out the A2,
of a real option the underlying value of the option is a one of the most important Dutch highways, from a 2x3
piece of property like a building, a piece of infrastructure to a 2x5 lane highway because of the growing demand
or a plot of land. The type of underlying value deter- for road traffic. The A2 connects the city of Amsterdam
mines whether an option is a financial option or a real with the city of Utrecht. The image below shows what
option. the renewed highway will look like once the project is
finished.
What are real options?
The term real option was introduced in 1977 by Stewart On the right side of the five lanes a service lane is avail-
Myers. He states that the value of a company is deter- able. On the left side a quite wide stretch of asphalt with-
mined by the value of its current real assets which have out a clearly defined purpose is visible. This stretch of
market values independent of the firm’s strategy and by asphalt gives the Dutch Ministry of Transport, Public
the present value of its possibilities to purchase real as- Works and Water Management a real option, i.e. an op-
sets on possibly favourable terms. Myers calls these pos- tion to expand.
sibilities real options. An example of such a real option is
the possibility for a company to buy the building next to Option type option to expand
the current factory building if more production capacity Uncertainty demand for road traffic
is needed. Option premium marginal costs for sixth lane
During recent decades the definition of a real option has Strike price change of road signs and
broadened. In contradiction to the options formalized in repainting asphalt
contracts real options can be part of a project more im- Option value saved overhead costs for
plicitly. For example the real option to abandon a project sixth lane construction project
does not necessarily have to be written in a contract but
is part of almost any project. Such an option does not re- The growth of the demand for road traffic is uncertain,
quire an initial investment (option premium) but will cost therefore it is uncertain if another lane is ever needed.
A2 Amsterdam - Utrecht highway
1) Myers, S.C. (1977).
Determinants of corporate borrowing.
Journal of financial economics, Vol. 5, pp. 147-175.
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3. SIG Special Interest Group section business cases and project finance
Still the Dutch Ministry decided to invest in the option to If more information on for example the demand for a
expand during the broadening project. Apparently the certain type of transport becomes available during a pro-
marginal costs of creating the option for a sixth lane now ject the need for the project may change, i.e. the project
are much smaller than the costs of constructing a sixth goals no longer correspond with the actual situation. If
lane in a separate project in the future. the course of a project is already fully determined it may
result in a situation in which the project does not fulfil
In what way is the use of real options beneficial to large the demand. Real options are possibilities to alter the
Infrastructure projects? physical outcome of a project. These options are deliber-
Large infrastructure projects (LIPs) are complex and are ately added to the project in order to maintain possibili-
realized during a relatively large time span. These two ties to respond to unforeseen events during the project.
aspects create a certain degree of uncertainty. Because This kind of flexibility is valuable because if more things
much information on the project’s future is yet unknown, become clearer during the course of a project this may
it is almost naive to make a fixed project plan and busi- lead to more certainty on the correctness of a chosen
ness case. When circumstances change, it can be wise to approach.
adapt a project to this new situation. In that case real There are quite a few methods to value real options.
options can make a difference. Almost all of them derive from financial theories and
share one important input variable. This variable is the
Adding real options to the business case of a LIP, i.e. uncertainty of the underlying value. A greater amount of
adding possibilities to alter the project at a pre-determined uncertainty will, in theory, lead to a larger option value
cost, makes it possible to reach good project results and a larger premium. If for example the demand for
under different circumstances. Options give managers road traffic is more volatile, chances are big that an
the possibility to reach good results under other circum- adjustment on the supply side will be more necessary
stances than those described in the initial business case. than if the demand for road traffic can be predicted with
In this way options may increase the value of a project. great precision. Being more flexible, i.e. being able to
adjust a project, in a volatile situation is therefore more
When deciding whether or not to purchase an option, the valuable.
option premium needs to set against the option value and
the strike price, adjusted according to the uncertainty – In practice it is rather hard to determine this uncertainty.
or the probability of going ahead. In order to determine the option value of a real option to
for example, buy a piece of land, you should know the
The value of a real option uncertainty of the value of this particular piece of land.
Traditionally the value of an investment project is deter- Especially in LIPs, data on the volatility of the underlying
mined by making use of the net present value method. value of the option are not available because of the
According to this method the value of an investment uniqueness of the project’s assets and the shortage of
project can be determined based on the project’s cash specific historical data on uncertain factors of the project.
flows and the discount factor. The discount factor is A decision tree analysis (possibly combined with Monte
based on the amount of uncertainty in the project. Carlo simulation) is in this case the best alternative
A higher degree of uncertainty corresponds to a higher method to determine the real option value.
discount factor and accordingly to a lower project value
(see figure below). The traditional perspective on project How to make use of real options in your
valuation presumes that a greater amount of uncertainty Large Infrastructure Project
decreases project value. In almost every investment project, real options can be
created or preserved. These options add value to a
project (although they cost money) because they add
flexibility to the project which makes managing the
project easier. With this flexibility it is possible to pursue
the project goals despite the uncertainty in the project.
When the initial project plan and business case are ready
it is time to consider the real options that can be created
or preserved within the business case. These options can
then be evaluated in different scenarios by decision tree
analysis in order to determine their value. Subsequently
the value adding real options should be documented and
preserved by the project management in order to be able
to effectuate these options in the project’s business case. _
2) Amram, M. & Kulatilaka, N. (1999). Real Options: Managing Strategic Investment
in an Uncertain World. Boston: Harvard Business School Press.
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