A model for the optimal decision timing using a real options approach

Abstract

The net present value (NPV) rule has been the most widely used criterion to evaluate investment opportunities. However, analyses based on the NPV rule fail to consider the managerial flexibility of deferring decisions until major uncertainties are resolved. Recently, the real options method has attracted significant attention as a powerful approach to address this problem. If a decision to invest is delayed, the value of the investment opportunity increases with the knowledge of uncertainty resolutions, but opportunity cost increases at the same time. Therefore, it is important to determine the optimal timing in terms of how long the decision should be delayed. In this paper, we develop a model deriving the optimal decision timing. Using a real options approach, the model derives the optimal timing until the point in time where a decision has to be delayed. The model will be very useful to address the problem of managerial flexibility in the NPV decision criterion. As an example, the model was applied to a telecommunications service company seeking to invest in a wireless resale business.