In The Capital Budget And Real Options Theory And Applied Research

MM theory, which claims that company value is determined by the profitability and risk degree of the capital investment, established the theoretical foundation of modern corporate finance. It clarifies the correlation between the value of company and the capital investment decision for the first time with models. Capital budgeting becomes the most important function of financial management, considering its feature.An established system based on discounted cash flow (DCF) has been formed and utilized in the field. However, there exist many defects in the traditional DCF approach both theoretical and practically. DCF approach shows some deficiency in valuing those investments that is highly uncertain and complex. The Real Options approach (ROA) overcomes the deficiency of traditional DCF approach and shows great advantage in situation of great uncertainty. ROA takes into consideration the managerial flexibility and options, employing the options pricing theory in pricing these options. It helps management make the best decision, in line with the goals of value maximization.This paper is a research on the real options theory and application in the field of capital budgeting. The paper contains five main parts:1. A review on real options theory development in capital budgeting;2. The failure of the traditional discounted cash flows approach and the comparative advantage of real options analysis under uncertainty;3. The introduction to financial options theory and options pricing models, which gives an overall picture of the nature of options;4. An overall description of real options approach, including the definition and real options valuation approach;5. The paper presents an extended capital budgeting procedure based on real options analysis.