The Application Of Real Option In Project Investment Decision Making

In recent years, with the rapid development of China's economy, project investment decision making is increasingly become one of the important tasks that private corporations and government administrations are facing with. Because of the growing degree of complexity of today's social, economy and political environment, the traditional method is lacking of flexibility in investment decision making and cannot meet the needs to evaluate the value of the project in the actual uncertain environment. The Real Option method makes up for the deficiencies of the traditional method. Its applicability and flexibility make it a more accurate assessment of the value of the project in the complex and uncertain environment, effectively supporting the decision maker with right investment decisions. Therefore, the study of Real Option method, especially the study of the application of the method in reality, is of theoretical significance and practical value.The idea of Real Option is first suggested by Stewart Myers, a scholar in MIT, in 1977. After 30 years of development, the theoretical system is gradually improved. But in practice, although it has been preliminary applied, is not popularized. In China, the introduction of the Real Option idea is late, and the practice of the idea is not very extensive. The reason for it is that the introduction of theoretical ideas and models in the project cannot effectively guide the practical decision makers with proficient application of the method. Especially when the real cases are not enough, the advantages of using the Real Options method is not fully apparent, so the use of the method by most of the decision makers is prohibited.This paper uses the research method of combining theoretical description with empirical analysis. Firstly, it introduces the concept as well as the types of Real Option combined with analysis of the survey data of foreign practice to clarify the applicable conditions of Real Option, the basic ideas and the basic application framework. Then this paper introduces and analyzes the idiographic cases of Real Option at home and abroad. By summing up experience and drawing lessons from the past practices, it illustrates the superiority of Real Option method and points out possible problems that may occur in the practices under different circumstances. Finally, according to the research findings by foreign scholars and previous empirical studies, the paper summarizes the lessons learned for applying Real Option method in the actual project investment decision making as well as the coping strategies suitable for China.The paper has five parts:The first part explains the purpose as well as the significance of the study and then sums up the research achievements in this field by domestic and foreign scholars. Finally it presents the contents of the study, the basic framework, the innovations and shortcoming of the paper.The second part briefly gives an overview of Real Option concept, then citing several main types of Real Options, using a decision making case of a natural resource exploitation company's new land exploration project.The third part starting, with the description of an investigation made by foreign scholars on the actual use of Real Option, and then summarizes the application conditions of Real Option method according to the result of the investigation. After that the paper uses a combination of graphics to set out the basic frame work and key features of Real Option thinking.On the basis of the study of foreign scholars, the paper briefly introduces the concept of Option Chain to support the idea of Real Option elaboration. Finally, the paper proposes a framework for the application of Real Options, and describes a step by step approach of practical application.The fourth part is an important part of the paper. Firstly, through the introduction of a new medicine launch by U.S. pharmaceutical company Eli Lilly, the paper describes the starting point and basic ideas of applying Real Option method to concrete problems. By means of the exhibition of the projects'subsequent developments after using Real Option method the case study illustrates the superiority of Real Option method and the importance of external environment analysis on the use of the method. Secondly, this part introduces a sewage treatment plant construction tender project using TOT model in south China. Through the explanations of the specific value of the project and decision alternative analysis under Real Option method, it proves of the application of the method, especially the significance in guiding the tendering and negotiation process of government owned big infrastructure projects construction. Thirdly, this part introduces a new car purchase decision project case of a U.S.rental car company. By means of showing the calculation of the project value, the comparison of decision alternatives and the various types of Real Options exist in the project under different external conditions; it clarifies the value of real Option method in capital budgeting decision making process, and points out some of the defects of using the method.The fifth part is the summery of the whole paper. It continues the above introduction of foreign scholars' investigation, start with a summarization of the potential difficulties and obstacles that may encountered in practical applications, it then combines China's specific national conditions, to put forwards the problems that should be noted in the application of Real Option idea in the production practice.The main innovation of this paper is the introduction and analysis of foreign scholars' survey data of Real Option method's practical applications as well as the actual cases at home and abroad in recent years. It is believed that to put the Real Option method into investment decision making practice, relying solely on theory study is not enough. The investigation of real cases, in particular the study and analysis of research data in developed countries which have some experience in the application of Real Option method, have some significance in improving the academic and business circles'understanding and practice of Real Option thinking, as well as in enhancing the quality of our investment decision making.However, because of the limitation of the author's academic and applied mathematics ability, the understanding and analysis of Real Option method in this paper is mainly focused on the investigation and study of basic thoughts and basic approaches. The analysis of Real Option model construction, deduction and calculation in practice is not enough. At the same time, due to the lack of practical experience of the author, there may be some inaccuracy or errors in the understanding of Real Option ideas and in the problem solving process of practical cases which need improving.