The incorporation and valuation of operational flexibility and of strategic value of investments in the decision-making process under uncertainty. The option nature of the investment decision arises from the coexistence of uncertainty, irreversibility, and timing flexibility and allows reaping upside potential while insulating from downside risk.
The decision to allocate resources to investment opportunities is traditionally evaluated using a net present value (NPV) approach for private sector projects or a cost-benefit approach for public sector projects. Typically, it sums all the incoming and outgoing cash flows over the lifetime of a project, each discounted at an appropriate risk-adjusted discount rate to derive its present value. The latter is compared with the (current) initial investment cost needed to start the project. In case the outcome of this comparison renders a positive result, one decides to invest; in the other case, one rejects the project....
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