Management Views on Real Options in Capital Budgeting

By Baker, H. Kent; Dutta, Shantanu et al. | Journal of Applied Finance, January 1, 2011 | Go to article overview

Management Views on Real Options in Capital Budgeting


Baker, H. Kent, Dutta, Shantanu, Saadi, Samir, Journal of Applied Finance


We survey a large sample of Canadian firms to first learn whether they use real options, the types of real options used, and why firms do not use them. Only 36 of the 214 respondents (16.8%) report using real options, which ranks last among nine capital budgeting techniques. The main reason for using real options is to provide a management tool to help form a strategic vision. The most commonly used real options are growth options and options to defer. Managers report that a lack of expertise and knowledge prevents them from using real options. Our evidence suggests that contrary to optimistic predictions; the use of real options appears disproportionate to their potential as a capital budgeting tool.

The concept of real options has been around for more than three decades. According to Borison (2005), the topic attracted moderate interest primarily among academics in the 1980s and 1990s. However, beginning in the mid-1990s, interest in the concepts underlying option valuation and the techniques of valuation increased substantially. As Borison (2005, p. 17) states, "All in all, real options has made the transition from a topic of modest, specialized interest to one that now receives active, mainstream academic and industry attention." Today, there are numerous books (e.g., Amram and Kulatilaka, 1999; Chance and Peterson, 2002; Copeland and Antikarov, 2003; Mun, 2006; Kodulula and Papudesu, 2006; Guthrie, 2009) and hundreds of published articles on real options. The Social Science Research Network (SSRN) contains an extensive list of working papers on this topic.1

Although the subject of real options is enjoying a bull market in academe, top managers do not appear to share this increasing interest in adopting real options. As Chance and Peterson (2002, p. 95) note, "Empirical research has provided some, but very limited, support for the real-world applicability of real options models." For example, survey evidence documents that only a relatively small percentage of firms in the United States and Europe use real options as an evaluation technique in capital budgeting (Triantis and Borison, 2001; Graham and Harvey, 2001; Ryan and Ryan, 2002; Brounen, de Jong, and Koedijk, 2004; Block, 2007). Mathews, Datar, and Johnson (2007) attribute the slow development of real options to the complexity of the techniques and the difficulty of fitting them to the realities of corporate strategic decision-making.

Capital budgeting surveys often share the main goal of assessing whether a firm's current practices conform to finance theory. With the exception of Block (2007), surveys provide little rationale for the low popularity of real options because they simply report the percentage of responding firms using real options. Hence, direct evidence from decision makers on many issues involving real options is largely absent from the literature.

To address this deficiency, we survey a large sample of chief financial officers (CFOs) of Canadian firms to investigate their views on using real options as part of the capital budgeting process. Our study is important for two major reasons. First, our evidence on the use of real options among Canadian firms complements several US and European surveys. None of the existing capital budgeting surveys dealing with real options focuses exclusively on Canadian firms, which are much smaller, on average, than their US counterparts. As Bruner (2002, p. 50) notes, "The task must be to look for patterns of confirmation across approaches and studies much like one sees an image in a mosaic of stones." Second, our evidence should be particularly important to practitioners because we identify the types of real options firms most often use and present the obstacles prohibiting firms from employing real options. We obtain this evidence directly from managers of firms that either use real options or have considered using them. Hence, our study contributes to the literature by offering insights on several issues about real options not previously available from management surveys. …

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