How,in General,is Value Derived from Options on Real Assets

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The Answer is When the flexibility is retained in capital budgeting projects to change the scope of the project-whether that means an expansion in the case of a profitable venture or abandonment in the case of a disastrous venture-then the project has an implicit option value.While there was no explicit premium paid,the initial cost of the project may have been enlarged to plan in this degree of flexibility (e.g.,paying higher supplier prices to avoid long-term contracts,or leasing rather than purchasing,etc.).In general,the value of the option is the market value that can either be added to or subtracted from the firm as a result of exercising the option.To clarify the "subtraction" of value from the firm,remember that in the case of abandonment,the project NPV is negative and exercising the option just makes it less negative.

How,in General,is Value Derived from Options on Real Assets

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