Application Of Real Option Theory In The Investment Decision

The core of investment decision is to compare the value and cost of an investment and decide the feasibility. The traditional investment decision methods, represented by Net Present Value method, compare the present values of expected income and cost stream to make the decision. Although they consider the reward of time and risk, they ignore the strategic value of creating following growth opportunities and the flexibility to adjust according to the market changes. Real Options Theory properly describes the ignored value through the concept of "Real Options", and provides a practical qualitative tool.Fist, this paper points out the parallel between investment opportunities and financial options, and there after introduces the concept of "Real Options". Real Options are the rights, not the obligations, endowed to the investors by an investment opportunity, which they can choose to exercise or abandon after a certain time. Real Options appear as different types. This paper defines and analyzes each of them. The difference between Real Options Theory and traditional NPV is also compared to show the latter's defects and farmer's superiority.Next, this paper introduces how to use option valuation theory to value real options. That is. Binomial equation model and B—S model.Then, this paper analyzes cases having various types of option features to discuss how to use Real Option Theory to instruct investment decisions in China's environment.Finally, this paper advances further to analyze complicated economic phenomena through a Real Options view.