How do real options add value in capital budgeting?

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Answer

Real options recognize managerial flexibility—to expand, defer, abandon, or switch a project—that standard NPV ignores. Valuing these options (e.g., the option to abandon if things go badly, or expand if successful) can justify projects that look marginal on NPV alone, capturing the value of flexibility under uncertainty.

Real-world example The option to abandon a pilot project if it underperforms adds value beyond its base-case NPV.

Common follow-ups: What flexibility do real options capture? | Why does standard NPV understate them?

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