Real Options Analysis and Strategic Decision Making

Edward H. Bowman, Gary T. Moskowitz

Organization Science · 2001 · 348 citations · 20 references

Concepts

TL;DR

The real options approach is frequently advocated as a radical reassessment of the value of risk and exploration. The study examines a Merck R&D investment case to illustrate problems with applying real options. The authors analyze Merck’s use of real options to justify an R&D investment. They find that standard option valuation assumptions often conflict with strategic conclusions, requiring customized models, which may explain the limited adoption of real options in strategy.

Abstract

The real options approach is frequently advocated as an approach that offers a positive and radical reassessment of the value of risk and exploration. We examine a recent case where Merck used the real options approach to justify an investment in an R&D project. This case is used to highlight some of the problems associated with using real options. We note that the assumptions incorporated in most standard option valuation models can conflict with the conclusions reached by strategic analysis. As a result, users of real options models should understand the quantitative aspects of these models, and may often need to create a customized model for each situation. The difficulty of developing customized models may explain, in part, the limited use of the real options approach in strategic analysis.

References

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