iBusiness, 2011, 3, 43-48
doi:10.4236/ib.2011.31007 Published Online March 2011 (http://www.SciRP.org/journal/ib)
Copyright © 2011 SciRes. iB
Real Options Literature Review*
Shihong Zeng, Shuai Zhang
Finance Department of Economics Management School, Beijing University of Technology, Beijing, China
Received October 19th, 2010; revised November 19th, accepted 26th, 2010.
After 30 years of discussion and research, the academic community has established a complete theoretical system of
real options and provided an excellent framework for the use of real options theory in the investment appraisal of
high-tech projects. An option is an entitlement without any obligation and it has been used to describe a variety of
management decisions in business investment. The description of management is effective and proper. Due to the in-
troduction of real options theory, there has been a major breakthrough in the investment area. Project evaluation is the
core content of bank credit risk assessment and business evaluation. The core content never changes from the invest-
ment evaluation framework to the credit risk evaluation fram ework. The project evaluation meets various needs of sub-
ject s in different ways. In this paper, the importance of real options is analyzed and the literature is reviewed.
Keywords: Real Options, Literature Review, Enterprises
A knowledge economy speeds the development of sci-
ence and technology enterprises. There were 55 National
Level High-Tech Industrial Development Districtsestab-
lished by 2008, with a total output value break zone GDP
of 1.5 trillion Yuan RMB (REN MING BI) in these dis-
tricts. In China, this accounted for 5%. This is greater
than 11 percentage points over the same period of the
GDP. These districts created 80% of the scientific and
technological achievements of the country. Zhongguan-
cun Science and Technology Park Zone in China, for
example, are the most active areas of innovation and en-
trepreneurship in China. There have been more than
3,000 high-tech enterprises founded and 100 or more of
them produce an annual 100 million in sales revenue. A
large number of the scientific and technological achie-
vements made by these enterprises have effectively pro-
moted technological advances and market competition.
They play an important role in product innovation, in-
dustrial restructuring, employment opportunities and
the rise of the regional economy.
Scientific and technological enterprises develop rap-
idly, but financing bottlenecks become the primary ob-
stacle restricting their development. On October 30, 2009,
28 companies were officially listed on the GEM. Relative
to China’s vast scientific and technological enterprises,
there is a long way to go to get their economic power to
the open market and financing directly at this stage.
Currently, bank loans are still the main channel of fi-
nance for technical enterprises.
Large fluctuations will occur in short-run operating
activities because of the great risk and uncertainty of the
high-tech enterprises, so it is difficult to make a reason-
able forecast of a company’s future by means of its in-
formation and project data items. These problems lead to
the banks having great difficulties in making correct
judgments when high-tech enterprises and high-tech pro-
jects need bank loans.
It is an internal control issue in credit risk when a bank
decides to accept high-risk technology companies and
accept scientific and technological projects. The bank
must set up a strong credit risk identification, supervision
and management mechanism. Since the People's Bank
provides a floating rate for a loan, banks can not offset
high risk by demanding high interest rates. If banks take
the high risk, they cannot obtain corresponding income
subsidies to cushion against losses. Because of this, most
banks often refuse to lend to high-tech projects whose
risks are high. It is not easy to get loans for high-risk
companies and this problem is the bottleneck that re-
stricts the development of high-tech companies.
*The research was achievements of the current stage of 2011 Beijing
hilosophy & Social Science research p
ogram (2011 Beijing Education
Committee key project): a subtopic of study on financial development in
Beijing. The research was supported in part by The China Scholarship
Council (CSC) (3036) .
Real Options Literature Review
Real options evolve from the financial option. Its
original intention was to deal with future uncertainties of
a project’s implementation, so real option, bank credit
risk and purpose of the evaluation are the same by virtue
of the fundamental nature of an option. After the intro-
duction of option evaluation methods, many investment
decisions which previously needed intuitive decision-
making can now be illustrated with a quantitative de-
scription. Corporate management decisions can also be
guided by applying a scientific calculation and estima-
tion. Therefore, applying real options to risk assessment
of bank’s credit has a very important practical signifi-
2. Western Literature Review
After many decades of development, real options theory
has become an important branch of finance, it is also a
current hot topic in academic finance. Both theoretical
and applied researches about real options are definitely in
the ascendant and have achieved remarkable results. The
descriptions in this section make a comprehensive analy-
sis of three aspects of the current literature: the real op-
tions theory, the differences between the real options
theory and the traditional theory in decision-making and
the application of real options.
2.1. Introduction of Real Options
Myers (1977)  first proposed the “real options” con-
cept, and pointed out the similarities between the finan-
cial options and real options. The company can obtain a
right after it has made an investment decision. It can use
the right to buy or sell a ph ysical asset or investment plan
in the future. When the investment project has a highly
uncertain characteristic the project's value should be
equal to the Net Present Value (NPV) of the project plus
the value of the future option .
Ross (1978)  made an an alysis of risky projects. He
found the inherent potential investment opportunities, he
considered such an investment opportunity as real op-
tions, and then discussed the theory of real option valua-
Trigeorgis (1993)  divided the real options into
seven categories according to the differences in flexibil-
ity : Option to Defer, Staged Investment option, Option
to Alter Operating Scale, Option to Abandon, Option to
Switch, Growth Option, and Interacting Option.
Amran and Kulatilaka (1999)  applied option pric-
ing theory and the financial market rules to the evalua-
tion of non-trading assets, helping managers make use of
their own option right to make management decisions in
option areas such as strategic investment, R&D project
selection and so on.
2.2. The Difference between Real Option Theory
and the Traditional Decision-Making Theory
Myers (1984)  laid out the limitations of Discounted
Cash Flow (DCF), and analyzed the importance of a
company's strategy in the capital budget process. He
recommended that much investment should be decided
by options pricing rather than the DCF approach.
Hodder and Riggs (1985)  pointed out that the DCF
method has been misused in practical applications. Be-
cause the project risk gradually decreases as the project
becomes ongoing; and management flexibility may also
reduce project risks; using only one discount rate
throughout the project’s assessment process is inappro-
Trigeorgis and Manson (1987)  pointed out that
when the managers used traditional NPV or DCF to
make decision, their theories are based on the assumption
that the estimated future cash flows can be estimated on
the premise of the future certainty. Therefore if uncer-
tainty exists, the NPV or DCF can not estimate the man-
agement flexibility of changes in the investment deci-
sion-making. So in terms of investment analysis in an
uncertain environment, it may produce a biased result of
an investment program by the NPV.
Brealey and Myers (1992)  found that R&D in-
vestment will bring an option for the company within a
specified time period. The company has a right to decide
whether to implement the investment follow-up project.
If the R & D fails, the loss is only the initial investment
costs. If the projectis successfully developed, therecould
be a follow-up for enterprises to create greater value. R
& D investment costs can be regarded as a royalty for
this option, which is very similar to a Call option. So
they proposed that the Option Pricing Theory can be ap-
plied in the evaluation of R & D investment programs.
Dixit and Pindyck (1995)  maintain that traditional
investment decision-making assumes that the strategic
decision-making of corporate planners can not be de-
ferred. If the company does not make the investment now,
it will lose the opportunity forever. The company must
choose a decision of whether to invest at a particular time
without any change in the decision-making which ig-
nores the value created by the delay of investment deci-
sions, resulting in errors on the project value. Thus, this
makes the entire investment a decision-making error. In
fact, the investment project can wait until more informa-
tion appears, then make the investment decisions.
Ross (1995)  points out that the NPV and other
traditional methods may result in wrong invest ment deci-
sions. For example, some investments which include
some follow-up investment are incomplete at one-time. If
the upfront investment can not be in line with the stan-
Copyright © 2011 SciRes. iB
Real Options Literature Review45
dard positive NPV, it may not be approved by the man-
agement. While the NPV method advocates “now ac-
cept” or “never accept” criteria, it obviously is not con-
ducive to assessing the present and the future value of the
2.3. Application of Real Options
Lander and Pinches (1998)  summarized these appli-
cations in 16 aspects: such as natural resources, competi-
tion and business strategy, production, real estate, R & D,
public good, mergers and acquisitions, corporate gov-
ernance, interest rates, inventory, labor, venture capital,
advertising, legal, hysteretic effect and corporate behav-
ior, environmental development and protection. We have
selected the more prominent areas of research literature
to be reviewed.
2.3.1. The Area of Natural Resources Investment
The product price in the area of natural resources in-
vestment has the characteristic of a high degree of ran-
dom fluctuation, which also requires enterprise manage-
ment capabilities to us e arbitrage opportunities.
Brennan and Sehwaaz (1985)  studied the problem
of how to estimate the value of a copper mining project
with a high-risk cash-flow. In their research, they con-
structed a financing portfolio including short-term assets
of futures contracts, and long-term assets of mineral re-
sources, and then obtained a partial differential equation
of copper values.
Trigeorgis (1990)  analyzed the assessments of a
multinational natural resource project. The NPV of the
project was negative, but the managers identified these
options by the binary option pricing methodology: delay
options, abandonment options and options of conversion
scale during the course of the project, concluding that the
NPV of the project was positive and the implementation
of the project finally succeeded.
2.3.2. Land (Real Estate) Development Areas
Many investors want to retain land, waiting for a more
favorable opportunity to invest.
Titman (1985)  adapts the option pricing methods
which were first used by Fisher Black, Myron Scholes
 and Robert Merton  to estimate the value of the
undeveloped land wh ere the future price of bu ilding units
is uncertain. They assumed the vacant land as a Call Op-
tion, the construction costs as the strike price, and deter-
mined the vacant land’s value through a combination of
construction cost and go ver n m e nt bonds.
Quigg (1993) [17 ] found that the price of undeveloped
land is 6% higher than the average price of developed
land by empirical analysis of Seattle real estate transac-
tion data between 1976 and 1979. This figure almost
equals the average premium paid by real estate develop-
ers in the process of purchasing land at the same period
in Seattle. Holding the undeveloped land was the
equivalent of holding an American-style call option. She
also derived a land evaluation model with options.
Capozza and Sick (1994)  considered that agricul-
tural land converted to urban land can be seen as an
American-style call option. Their results show positive
correlation between the price of the land waiting for
conversion and the rent price of urban land. When urban
land rental prices become more volatile, the option of
agricultural land dev elopment will be more valuable.
2.3.3. The Field of Corporate Stra tegy
Keser (1984)  considered that under the traditional
decision-making methods, even the negative NPV pro-
jects, so much as there is a long-term strategic value,
they may be worthwhile investments. In the evaluation of
such projects, the real options approach should be used.
When competitors have the same options, the enterprise
should implement options as soon as possible in order to
Kulatilaka and Marks (1988)  stud ied the strategic
value of flexibility options. They constructed two com-
panies to make comparative studies; the assumptions
were that one enterprise can use only a certain technique,
while another enterprise has several choices of technol-
ogy. This flexibility o ption gives the later one a strategic
2.3.4. The Field of R & D Areas
Uncertainty and high risk are the main features of R & D
projects. Real option theory applied to R & D project
management has gradually become one of the main
trends of research since 1980s.
According to the studies of Morris, Teisberg and
Kolbe (1991) , active managements could gradually
reduce the risks in the process of investment. As more
value could be had by the flexibility of management,
they suggest choosing the projects of which have much
more risk when the expected benefits and costs of items
are as near as making no difference.
Nichols (1994)  pointed out that the DCF method
can not properly assess volatility. It often underestimates
the investment value of the pharmaceutical R&D projects
such as science and technology enterprise. Merck Com-
pany has been using the real options approach in project
2.3.5. The Field of Enterprise Valuation
Chung and Charoenwong (1991)  considered that
certain enterprises do not need to become involved in
investment opportunities if they can recognize th e option
of future investment as th e value of growth opportunities.
A firm’s value should include the company’s existing
Copyright © 2011 SciRes. iB
Real Options Literature Review
internal asset value and the value of th e company's fu ture
Kellogg and Charles (2000)  found that many
high-tech biotechnology companies have a high stock
price despite having no product revenue because their
products are in early stages of development. They use the
decision-tree method and binomial-lattice method to
value the high-tech company’s share price and found that
the real options evaluation methods reflect the high-tech
company's early value more accurately.
Schwart and Mo on (2000)  apply r eal options the-
ory and capital budgeting methods to assess the value of
Internet companies. They established a real options
model based on the continuous-time, estimate model
parameters, perform sensitivity analysis and apply the
results to the valuation of technology companies.
3. Chinese Literature Review
In China, research about real options began in the late
1990’s. Then the research boom of finance and manage-
ment emerged: research reviews, value assessment of
high-tech enterprises, natural resources, venture capital,
and business strategy decision-making, financing deci-
sion-making, real estate investment and development
decisions, theory research and so on took place.
In the research of Huang and Zhuang (2003) , the
theory and the model of principal-agent have been ap-
plied to real options based on the options value model.
They designed the profits model of real options, and cal-
culated the profits of investors and operators in real op-
tions. The results are regarded as investment decision
evidence in analysis of different information.
Liu and Ouyang (2003)  make the quantitative
analysis of strategic project investment decision-making
process base the theory of real options, and they build the
decision-making model. According to the results of the
model analysis, to acquire the option value of a strategic
project, decide whether the project should be invested or
not, and discuss the best investment opportunities. In the
end, they test the affect of various parameters on the
model results by examples.
Li, Qu and Feng (2003)  come up with a real op-
tion approach which is concerned with investment deci-
sion-making for the two-stage, It can be used to estimate
the flexible value and the corresponding optimal invest-
ment ratio in the market risk that the company faces. And
they test for the specific case. In the situation of correctly
estimating relevant variables, the approach can provide
great support for short-term investment decision-making.
Mu and Wang (2004)  set up a production project
investment option pricing model according to real op-
tions theory and a variety uncertainties that cause market
demand. They make a comprehensive analysis about the
affect of the uncertainty factor in the flexibility, man-
agement value, and investment decision-making by nu-
Xia, Zeng and Tang (2004)  introduce the present
situation of general real options and strategies real option
theory research, focusing on strategies of the real options
of enterprise technology innovation investment, and
making a more detailed category overview, further re-
search for these issues are given at the end.
Xia and Zeng (2005) [3 1] use the real options analysis
method to study the new technology’s optimal invest-
ment strategy of enterprises under the future multi-
generation of new technology. The results can be used to
predict the company’s investment strategy, and provide
theoretical support with the empirical analysis of new
technology adoption and diffusion.
J. Gao and L. Jiang (2010)  discussed the method
of real options to encourage R & D teams when the en-
terprises can not achieve the desired economic benefit in
the case of high-risk projects or the immature market.
The study on how to measure the credit risk of com-
mercial banks and build an integrated management sys-
tem is little developed in China. The overwhelming ma-
jority of domestic research is on the introduction of ex-
isting results of overseas research. The results related to
digestion and absorption of foreign research is still rela-
tively small. So far, it is very rare that some of the latest
approaches such as real options approach are used to
make empirical analytic study about credit risk meas-
urement and management of banks in China.
In short, economists have a wide range of research for
real options. The knowledge of Real Options in various
areas have been applied from the initial simple B-S op-
tion pricing formula and the binomial pricing model
transition to multi-stage, compoun d, real options models.
There is the beginning of considering the real op tion the-
ory under incomplete in fo rmation. Th e theo retical syste m
has developed and their applications related to many
We thank the fo llowing researchers for their con tribution
to the paper.
Ping He (professor in the school of finance, Renmin
University of China).
Li Zhou (professor in school of agricultural economics
and rural development, Renmin University of China).
Ming Ma (associate professor in the school of man-
agement & economics, Beijing Institute of Technology).
Copyright © 2011 SciRes. iB
Real Options Literature Review47
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Published Online: http://www.SciRP.org/journal/jssm