A Teaching Note on “Real Options”

Abstract

The engineering life is uncertain. We often need to make decisions now that we hope will be effective some years from now. One approach to this conundrum is to design “flexibility” into our projects, hedging against future uncertainties. This sounds reasonable and it is, but it is not “free”. Including flexibility is our design can be costly and if it turns out not to be needed in the future, it is money down the drain. So how do we know when to design in flexibility and when not to? Intuitively, the more uncertain we are about the future, the more the chances are that we will need flexibility. “Real Options Analysis” (ROA) is a method we can use to put a value on flexibility and decide whether or not we should spend the resources now to hedge against future uncertainties. This teaching note, prepared for an undergraduate class at MIT, is an approach developed by the author, to explicate these concepts.