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Are “Real Options” ActuallyUsed in the Real World?Stanley Block aa M. J. Neeley School of Business, Texas ChristianUniversity, Fort Worth, Texas, USAPublished online: 13 Sep 2007.

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The Engineering Economist, 52: 255–267

Copyright © 2007 Institute of Industrial Engineers

ISSN: 0013-791X print / 1547-2701 online

DOI: 10.1080/00137910701503910

ARE “REAL OPTIONS” ACTUALLY USEDIN THE REAL WORLD?

Stanley Block

M. J. Neeley School of Business, Texas Christian University, Fort Worth,

Texas, USA

The inability of classic NPV analysis to capture the future value of op-tions in a capital budgeting analysis is now well documented by Trige-orgis (1993, 2005), Copeland and Antikarov (2001), and others. In spiteof this, traditional NPV analysis continues to be described as a norma-tive approach. The author surveys Fortune 1,000 companies to see if theyhave picked up on the use of real options to complement traditional anal-ysis. Out of 279 respondents, 40 were currently using real options (14.3%).While the percentage is small, the number is higher than in previous stud-ies. The author goes on to describe in what manner real options are beingused and, of equal importance, why they are resisted by many. Somewhatencouraging is the intent of well over half the nonusers to consider the useof real options in the future.

INTRODUCTION

In their highly regarded book published at the turn of this century, Copelandand Antikarov (2001) suggested that real options would dominate the cap-ital budgeting process within the next decade.

As these authors and others, such as Trigeorgis (1993) and van Puttenand MacMillan (2004), have pointed out, the users of net present valueand other discounted cash flow methods may not consider the flexibilityto revise decisions after a project has begun. The flexibility might includeterminating the project, taking a more desirable route once initial resultsare in, greatly expanding the project if there is unexpected success, and soon. Such elements are particularly likely to be present in natural resourcediscovery, technology-related investments, and new product introductions.

Address correspondence to Stanley Block, M. J. Neeley School of Business, P.O. Box 298530,

Texas Christian University, Fort Worth, TX 76129. E-mail: s.block@tcu.edu

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256 S. Block

But the list does not stop here. Almost every capital budgeting projectcontains a potential element of flexibility once it is put into place. Thereis a real option to change the course of action, and this real option has amonetary value just as a financial option does.

While many proponents of real options are critical of NPV analysis, it isnot necessarily NPV analysis that is at fault per se, but rather the improperuse of it in many cases. One can use NPV analysis “correctly” if all options(invest, do not invest, delay, etc.) are known at the start of the project suchthat they all can be evaluated. This is why decision trees were developed.The benefit of real options analysis is that it incorporates volatility, whereasdecision trees (which rely on NPV analysis) only compute expected values.

CAPITAL BUDGETING STUDIES AND REAL OPTIONS

Capital budgeting techniques used in business have been studied exten-sively by Mao (1970), Gitman and Forrester (1977), Schall, Sundem, andGeigsbeck (1978), Scott and Petty (1984), Canada and Miller (1984), Block(2005), and others. The central message throughout is that major industrialfirms are moving toward the normative in various areas of capital budgeting.

However, the topic of real options is not covered or scores poorly interms of utilization. For example, as reported by Teach (2003), in 2000,Bain and Company conducted a survey of 451 senior executives covering30 industries regarding their views of management techniques, and only9% reported using real options. Also, Ryan and Ryan’s (2002) survey of208 CFOs found real options trailing the list of 13 supplementary capitalbudgeting techniques with a utilization rate of 11.4%. In contrast, 85.1%of the respondents used sensitivity analysis and 96% used traditional netpresent value analysis for basic capital budgeting. In both of these stud-ies, the inclusion of real options was an afterthought with no follow-upquestions or analysis.

The current article is specifically dedicated to real options with the intentof finding out who is doing what and why.

It is organized as follows. In the following section, the methodologybehind the current study is described; then the presently existing practicesusing real options are covered, the resistance to real options is analyzed,and a summary and conclusion follow, along with the future outlook.

METHODOLOGY UTILIZED IN THE CURRENT STUDY

The author used the Fortune 1,000 companies as the initial database for thestudy. Two hundred and seventy-nine usable responses were returned bythe top-ranking financial officer of the firm or his designate. The three-page

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Are “Real Options” Actually Used in the Real World? 257

questionnaire was based on a pilot study of 50 Fortune 1,000 companiesto ensure clarity of meaning.

A follow-up telephone survey of 40 randomly selected non-respondentssubsequent to the actual mail-out indicated no statistically significant dif-ference between those who initially answered the questionnaire and thosewho elected not to participate.

The financial characteristics of the participating firms are presented inTable 1. Of equal importance is the industry of origin of the survey partic-ipants. The industry listings of those firms who participated in the surveyare presented in Table 2. The 12 categories are the most representative ofthe two-digit SIC codes of the respondents. Not all categories are mutuallyexclusive, so the emphasis is on the firm’s primary area of activity. Thefraction of responding firms versus non-responding firms, broken down bytwo-digit SIC codes, was generally consistent across all categories.

PRESENTLY EXISTING PRACTICES

The question of primary interest is what percentage of the respondents usereal options as part of their capital budgeting process. Forty respondents,representing 14.3% of the survey participants, indicated the use of realoptions. Out of the 40 users, 18 indicated major utilization, 13 indicatedthey used real options as a supplemental tool, and 9 reported using realoptions to shadow the results of more commonly used methods.

In terms of the applications of real options to different types of decisionsby the 40 users, the answers are reported in Table 3.

While the categories are clearly not mutually exclusive, and many re-spondents indicated an overlap, it is apparent that the nature of the decisions

Table 1a. Characteristics of survey partici-

pants: total revenue of survey participants

Number

Under $2 billion 62

$2 billion to $4 billions 70

$4 billion to $6 billion 38

$6 billion to $8 billion 28

$8 billion to $10 billion 14

$10 billion to $15 billion 23

$15 billion to $20 billion 11

$20 billion to $30 billion 13

Over $30 billion 20

279

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258 S. Block

Table 1b. Characteristics of survey partici-

pants: net profit (loss) of survey participants

Number

Loss 29

0–$200 million 32

$200–$400 million 40

$400–$600 million 44

$600–$800 million 36

$800 million–$1 billion 22

$1 billion–1.5 billion 38

$1.5 billion–$2 billion 10

Over $2 billion 28

279

indicated has a high degree of uncertainty. Clearly, a new product introduc-tion has subsequent components in which a decision must be made to eitheradd additional resources, penetrate different markets, cut back on expen-ditures, or even abandon the project. The same type of decisions relate toresearch and development, mergers and acquisitions, and other categories.

INDUSTRY OF USERS

In their work, Triantis and Borison (2001) found that there were tenden-cies among those who employ real options to represent certain industries.Out of the 40 users in this study, 37 came from the following: technology

Table 1c. Characteristics of survey

participants: ratio of research and de-

velopment to total revenue of survey

participants (2005)

Number

0–1% 14

1–2% 31

2–3% 67

3–4% 79

4–5% 63

5–6% 17

6–7% 5

7–8% 2

Over 8% 1

279

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Are “Real Options” Actually Used in the Real World? 259

Table 2. Primary industry of survey par-

ticipants (2005)

Number

Beverages 3

Energy 25

Finance 31

Food processing 9

Health care 26

Manufacturing 57

Publishing 5

Retail 44

Technology 36

Transportation 12

Wholesale 9

Utilities 22

279

(13), energy (11), utilities (6), health care (4), and manufacturing (3). In-terestingly enough, finance had only two users and transportation had one.More will be said about the low participation rate by the financial sector(investment banking, commercial banking, etc.) later in the article.

A chi-square independence of classification test indicated that a nullhypothesis that there was no relationship between industry classificationand use of real options could be rejected at an alpha level of .01. The resultsare unknown in the appendix.

METHODS OF UTILIZATION

For the 40 firms that utilize real options, a follow-up question pertainedto what technique they used in their implementation. They were givenfour major categories as well as another category. The major choices werethose previously cited by Triantis and Borison (2001) in their research. Theresponses are shown in Table 4.

Table 3. Types of applications of real options

New product introduction 36.2%

Research and development 27.8

Mergers or acquisitions 22.1

Foreign investment 9.6

Other 4.3

100.0

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260 S. Block

Table 4. Techniques for using real options

Binomial lattices 16

Risk-adjusted decision trees 12

Monte Carlo simulation 9

Black-Scholes option pricing model 1

Other 2

40

Needless to say, the approaches are not mutually exclusive and manywere used in combination. The emphasis here is on the primary method ofutilization. Also, some respondents used slightly different names for oneof the four approaches listed here, but the intent was the same and wascategorized as such.

While the binomial approach is the most frequently used, it was thoughtby the respondents to be more simplistic than the risk-adjusted decisiontree approach or Monte Carlo simulation.

Although the Black-Scholes option pricing model is the key to valua-tion for financial options, the same cannot be said for real options. TheBlack-Scholes model requires knowledge of five variables: the price of theunderlying asset, the price at which the option can be exercised profitably,the amount of time before the expiration date, the risk-free rate of inter-est, and the volatility of the underlying asset. Many of these variables aresimply unavailable for real option analysis. For example, the time periodbefore expiration can be easily determined for a financial option but is notdiscernable for a real option, where flexible decision-making allows formany different potential exercise dates, depending on how the project isprogressing.

To determine if there were industry preferences among the four differentmethods of utilizing real options, a chi-square test was once again run inwhich the null hypothesis was that there is no relationship to the techniqueused with real options and industry classification. The null hypothesis couldbe accepted at almost any reasonable level of significance. There is no dis-cernable relationship between technique used and industry classification.The results are shown in part b of the appendix.

In their research, van Putten and MacMillan (2004), Trigeorgis (2005),and others have stressed the importance of treating real options as a com-ponent of expanded net present value rather than as a stand-alone approach.The NPV is determined and the value of the real option is added.

Total value = passive NPV + real option value + otheradjustments

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Are “Real Options” Actually Used in the Real World? 261

Thus, it is possible to have a project that has a negative net present valuebut a positive total project value because of the presence of the real option.By failing to account for the real option value, an incorrect decision maybe made. This is particularly likely to happen in projects in which thereis a high degree of risk but also a large amount of flexibility. The classicNPV approach, if not properly used, may fail to pick up the value of beingable to change the plan in the early, middle, or late stages of the project.The classic NPV is likely to have the greatest value in the early years ofthe project because of the time value of money, whereas the real optioncomponent may be more valuable in the later life of the project becauseuncertainty may be at its highest level and flexibility at its most valuablepoint.

Thus, classic, stand-alone NPV, if not properly used, may undervaluepotential rewards in the research for new drugs in the pharmaceutical in-dustry, the exploration for natural resources in the energy industry, and soon. Eighty two percent of the respondents employing real options indicatedthat they use the valuation of real options as a component (add-on) to theclassic NPV approach rather than as a stand-alone item. The classic NPVis retained but modified to reflect how managers think and act in the realworld.

Of further interest is the fact that 32% of the respondents indicated thatthe decision to reject was reversed after the introduction of real optionsinto the analysis.

NONUSERS OF REAL OPTIONS

Two hundred and thirty-nine out of the 279 respondents indicated they didnot use real options. When asked for the reasons why, the answers in Table5 were provided.

The number one reason for not using real options is the lack of topmanagement support. While that can take on many different meanings,further comments indicated that the top managers of many companies arehesitant to accept a methodology they cannot follow step by step. Many

Table 5. Reasons for not using real options

Lack of top management support 42.7%

Discounted cash flow is a proven method 25.6

Requires too much sophistication 19.5

Encourages too much risk taking 12.2

100%

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262 S. Block

felt that top management was turning decision-making over to mathe-maticians and decision scientists, and they were being taken out of theloop.

While van Putten and MacMillan (2004) emphasized that real optiondecisions could be simplified to a go, no-go approach to an investment,a number of respondents thought that was being patronizing to top man-agement and reduced top management’s perceived power as sophisticateddecision-makers.

The second reason given for not using real options is that discountedcash flow is a proven method and therefore a preferred method. One canhardly blame the respondents for taking an approach that is heavily favoredin the literature. The typical procedure in texts and corporate manuals isto downplay methods such as the payback period and the average rate ofreturn and highlight the superiority of NPV and IRR, which are basedon the time value of money and the use of cash flow rather than GAAPearnings. Real option–based books such as Copeland and Antikarov (2001),Amran and Kulatilaka (1998), and Trigeorgis (1996) drew little attentionfrom the nonusers. Many thought they were already using the normativeapproach.

The third major reason for nonutilization of the real options is that thereal options required a high degree of sophistication. Earlier in the articleit was suggested that the greatest utilization of real options was in tech-nology, energy, utilities, etc., and that is consistent with the fact that topmanagement in those industries often have engineering or technology back-grounds. Other industries such as retailing, food processing, and publishinghad virtually no utilization of real options.

Not only is top management more mathematically sophisticated in cer-tain industries, but lower level management, which does the initial analysis,may also be more mathematically sophisticated. An accounting major oreven an MBA may be less likely to engage in mathematically dependentreal option analysis than an engineer or scientist.

One respondent said, “Those with a background in the sciences andengineering love the challenges of dealing with real options. They want tomap the decision process and use their mathematical skills to address theissues.”

In order to isolate on the people making decisions, the author inquiredabout the background of the people generally thought to be in control. Dis-tinctions were made between scientific and financial backgrounds, anda null hypothesis that there is no relationship between the training ofdecision-makers and the use of real options was tested. The stated hypoth-esis could be rejected at an alpha level of .05 as indicated in part c of theappendix.

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Are “Real Options” Actually Used in the Real World? 263

The fourth reason given for the nonuse of real options is that they tend toencourage excessive risk-taking. As stated by van Putten and MacMillan(2004) based on their conversations with top executives:

For all their theoretical attractiveness as a way to value growth projects,

real options have had a difficult time catching on with managers. CFOs

tell us that real options overestimate the value of uncertain projects,

encouraging companies to over-invest in them. In the worst case, they

grant excessively ambitious managers a license to gamble with share-

holder’s money.

Thus, while real options were initially introduced to make companiesmore competitive by taking on projects that were difficult to evaluate be-cause of uncertainty, they have taken on a different reputation in the eyesof some executives. This is not a point to be taken lightly and requires thatacademics study the practitioner’s concerns in a rigorous manner in futurestudies of real options. Some of the resistance could be associated withacademia’s lack of understanding of the incentive effects of real options oninstitutional decisions.

Many respondents indicated that whether the methodology is corrector not, there is no assurance that operating managers will actually followthe decision-making options covered in the initial analysis. While theremay be a chance for abandonment in a latter stage of the project, thusrecovering part of the initial investment (under the use of real options orNPV analysis), managers at that point in time may have a vested interestin having the project continue because they have been identified with it.Discontinuation may even mean recognition of poor earlier judgment andloss of employment. One might suggest that until the corporate culture ischanged so that closing down existing operations is rewarded instead ofpunished, the implementation of the assumptions that are part of the realoptions process may not happen.

Both proponents of real options and those who resist them may suggestthat they are keeping their eye on the ultimate goal of stockholder wealthmaximization. Although Triantis and Borison (2001) maintain that this isone of the strongest arguments for the use of real options, a chi-square in-dependence of classification test indicated there is no relationship betweenthe use or nonuse of real options and the desire to maximize stockholderwealth as indicated in part d of the appendix.

Interestingly enough, those in the financial community where the goal ofstockholder wealth maximization is most widely touted showed little or nointerest in real options. It would appear that until the value of real options

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264 S. Block

is included into the valuation models used on Wall Street and elsewhere,there may be little movement in this area of finance.

However, the future for real options in the overall economy is not neces-sarily discouraging. As previously stated, 40 of the 279 respondents to thisstudy (14.3%) are currently using real options. Of the 239 nonusers, 43.5%indicate that there is a good chance they will seriously consider using realoptions in the future, 15.9% indicate that there is some chance, and only26.3% totally reject the potential of using real options.

SUMMARY AND CONCLUSION

The inability of classic NPV analysis to capture the future options in acapital budgeting decision is now well documented by Trigeorgis (1993),Copeland and Antikarov (2001), and others. The misuse of classic netpresent value analysis may understate the value of a potential investmentand lead to an incorrect decision, particularly when a high degree of uncer-tainty is involved. Instead of rewarding the asymmetric nature of returnsunder uncertainty in which future action can allow positive results, classicNPV may penalize future uncertainty through the risk-adjusted discountrate.

In spite of the points made above, the use of real options by U.S. com-panies is limited. From a mailing to the Fortune 1,000 largest companies,279 usable responses were returned. Forty respondents (14.3%) currentlyused real options in the capital budgeting process. However, the percentageis somewhat higher than that in prior studies and useful observations canbe drawn from the 40 users and 239 nonusers.

The users come primarily from industries where sophisticated anal-ysis is the norm, such as technology (13), energy (11), utilities (6),and other similar segments of the economy. Respondents were dividedinto 12 major industrial classifications and a null hypothesis that thereis no relationship between industrial classification and the use of realoptions could be rejected at an alpha level of .01 using a chi-squaretest.

The Black-Scholes option pricing model was rejected by almost all theusers in preference to such approaches as binomial lattices, decision trees,Monte Carlo simulation, and so on.

The nonusers of real options provide interesting information as well.In a time period in which the normative approach to the capital budgetingdecision is stressed as a key ingredient to stockholder wealth maximization,85.7% of the respondents are not using a valuable tool in the form of realoptions.

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Are “Real Options” Actually Used in the Real World? 265

The primary reasons given for nonuse of real options in order of impor-tance are (a) lack of top management support; (b) discounted cash flow isalready a proven method; (c) real options require too much sophistication;and (d) real options encourage excessive risk-taking.

On a more positive note, 43.5% of the nonusers said that there is agood chance they will consider the use of real options in the future, 15.9%indicate a positive but less committed response, and only 26.3% totallyreject the use of real options in the future.

REFERENCES

Amram, M. and Kulatilaka, N. (1998) Real options: Managing strategic investments inan uncertain world. Cambridge, MA: HBS Press.

Block, S. (2005) Are there differences in capital budgeting procedures between in-

dustries? An empirical study. The Engineering Economist, 50(1), 55–67.

Canada, J.R. and Miller, N.P. (1984) Review of surveys on capital budgeting evaluation

techniques. The Engineering Economist, 30(2), 193–200.

Copeland, T. and Antikarov, V. (2001) Real options: A practitioner’s guide, New York:

TEXERE LLC.

Gitman, L.J. and Forrester, J.R., Jr. (1977) A survey of capital budgeting techniques

used by major U.S. firms. Financial Management, 6(3), 66–71.

Mao, J.C. (1970) Survey of capital budgeting: Theory and practice. Journal of Finance,

25(2), 349–360.

Ryan, P.A. and Ryan, G.P. (2002) Capital budgeting practice of the Fortune 1,000:

How have things changed. Journal of Business and Management, 8(4), 355–

364.

Schall, L.D., Sundem, G.L., and Geigsbeek, W.R. (1978) Survey and analysis of capital

budgeting methods. Journal of Finance, 33(1), 281–287.

Scott, D.F., Jr. and Petty, J.W. (1984) Capital budgeting practices in large Amer-

ican firms: A retrospective analysis in synthesis. Financial Review, 19(1), 111–

123.

Teach, E. (2003) Will real options take root? Available at: http://www.CFO.com

(accessed)

Triantis, A. and Borison, A. (2001) Real options: State of practice. Journal of AppliedCorporate Finance, 14(2), 8–24.

Trigeorgis, L. (1993) Topics in real options and applications. Financial Management,22(3), 202–223.

Trigeorgis, L. (1996) Real Options; Managerial Flexibility and Strategy in ResourceAllocations. Cambridge, MA: MIT Press.

Trigeorgis, L. (2005) Making use of real options simple: An overview and applica-

tions in flexible/modular decision making. The Engineering Economist, 50(1), 25–

53.

van Putten, A.B. and MacMillan, I.C. (2004) Making real options really work. HarvardBusiness Review, 82(12), 134.

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266 S. Block

APPENDIX

Chi-Square Independence of Classification Tests

Alpha

Null hypothesis χ2 D.F. .01 .05 .10 Conclusion

a. Use of real options is

independent of

industry classification

27.627 11 24.725 19.675 17.275 Reject the hypothesis at

at .01 level of

significance. Industry

classification has a

significant

relationship to the use

of real options

b. The techniques used

for real options is

independent of

industry classification

18.268 19 36.191 30.44 27.204 Accept the hypothesis.

Industry classification

does not have a

significant

relationship to

technique used

c. Use of real options is

independent of the

training of

decision-makers

32.197 19 36.191 30.144 27.204 Reject the hypothesis at

a .05 level of

significance. Training

of decision-makers

has a significant

relationship to the use

of real options

d. The goal of

stockholder wealth

maximization is

independent of the

use of real options

4.173 3 11.345 7.815 6.251 Accept the hypothesis.

The use of real

options does not have

a significant

relationship to the

goal of stockholder

wealth maximization

BIOGRAPHICAL SKETCHES

STANLEY BLOCK, Ph.D., C.F.A., is professor of finance and holder of the Stanley Block En-dowed Chair of Finance at Texas Christian University, Fort Worth. He is the coauthor withGeoffrey Hirt of numerous books in finance including Foundations in Financial Manage-ment and Fundamental of Investment Management. The first text has sold over a millioncopies. He has published approximately 50 articles in such journals as Financial Manage-ment, The Journal of Financial Services Research, Journal of Portfolio Management, TheJournal of Accountancy, The Financial Analysts Journal, The Engineering Economist, and

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Are “Real Options” Actually Used in the Real World? 267

the Journal of Finance. He is past president of the Southwestern Finance Association anda former director of the Financial Management Association. He serves as consultant to anumber of companies throughout the world and has held board of director positions withthree publicly traded companies. At TCU he has twice won the award as the outstandinginstructor in the MBA program.

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