Real Options Analysis in Strategic Decision Making: An applied approach in a dual options framework

Abstract

There is growing interest in real options theoretical perspectives to guide both capital budgeting and strategic decisions in dynamic environments. In contrast to the conventional use of discounted cash flows in capital budgeting and competitive analysis in strategy, a strategic options perspective provides a more proactive assessment of future business opportunities under uncertainty. Real options theory has shown potential for analytical applications in strategic management, particularly to evaluate flexibility and timing issues. Yet the options approach has not been widely incorporated to analyse business opportunities and adaptability in strategic investment decisions. There is a discrepancy between the mathematical sophistication of option pricing models developed in financial economics and the theoretical applications in strategic management. The paper aims to bridge this conceptual gap and promote wider use of an options analytical approach. A basic dual options framework that distinguishes between abandonment and deferral option scenarios is presented to analyse different strategic investment situations. The framework explicates how firms invest in business development and explains the frequent deferral of strategic investments. Parameter sensitivities in the option evaluation models allow appraisal of value effects from environmental uncertainties, but also point to limits of excessive model refinements. Both advantages and limitations of the options analytical framework in strategy are discussed, and unresolved issues are outlined for future research efforts.