The value of flexibility - A real option approach to capital budgeting

Abstract

This paper discusses different approaches to the capital investment process. The main focus is on investigating the practical aspects when applying real option theory to capital budgeting. We apply an extended framework introduced by Timothy A. Luehrman (1997) to a case study for Gothenburg Energy AB. The project is evaluated based on different assumptions in three separate scenarios. The results form each scenario are discussed in context of the applicability of the real options approach to the investment decision. Further, the robustness of the results to different assumptions about the evolation of the project value is examined.