The real option analysis is a new tool in capital budgeting that enhances chances of fair decision-making with regard to capital expenditure. This article discusses the advantages of ROA over the existing capital budgeting techniques. Further, it explains valuation models with illustrations.

Real Option Analysis (ROA) provides the management to take a right decision before incurring in a capital budgeting decisions. The term real option is relatively new to the business world, but it has been used in analyzing investment options. This term was coined by Prof. Stewart Myers at MIT Sloan School of Management around 1977 and then popularized by Micheal J Mauboussin. Mauboussin used this concept to explain the gaps between how the stock market values the businesses and the intrinsic values of those businesses.

The ROA can be used both as a qualitative and quantitative tool. As a qualitative tool, it provides an insight into the options available, probability of success and investment break-even points. It helps in determining the effective process for selecting the components of an investment plan and for monitoring investment decisions with the use of increasing information about the project and commercial possibilities. As a quantitative technique, ROA helps in taking decisions regarding complex multi-level projects by considering the account risk and uncertainty.

Real Option Analysis, Mauboussin, Discounted Cash Flow, DCF, Net Present Value, NPV, Cumulative Standard Normal Distribution, Strategic Planning, Risk Simulator Software, Dynamic Business Environment.