Flexibility in investment decisions under uncertainty: do managers behave according to real options theory?

Abstract

Despite the plethora of theoretical papers on real options, comparatively few papers test the predictions of real option theory empirically, and almost none directly examine decision making that applies real options theory. In contributing to the understanding of real options thinking, this research addresses the direct question of whether or not managers behave according to real options theory under controlled experimental conditions.

An additional contribution of this research is in the use of discrete choice experimentation as an instrument for studying real options decision-making. Whether managers would value two-stage capital investment decisions—as predicted by real options theory—was tested, as was the extent to which their preferences aligned with theory.

Managers’ responses corresponded, in part, with real options theory: investment values generally increased with lower option premiums and with higher payoffs. However, responses deviated significantly from real options theory when assessing the effect of uncertainty: respondents tended to incorrectly allocate lower values to investment alternatives with higher uncertainty. Responses also deviated significantly when assessing the effect of time to expiry: respondents tended to incorrectly allocate lower values to investment alternatives with longer times to expiry. This aspect is fundamental to real options theory and thus the findings of this research do not support real options thinking as being the best approximation of behaviour.