Uncertainty and Real Options

Can you see the real me?
Can you? Can you?
--The Who

Investment is the act of incurring immediate cost in expectation of future rewards. Investment decisions generally share three characteristics (Dixit & Pindyck, 1994). First, the investment is irreversible to some degree. Should you change your mind and want to unwind the investment, its initial cost cannot be completely recovered. It is at least partially sunk.

Second, the future rewards associated with the investment are uncertain. Alternative outcomes associated with higher or lower rewards might be identifiable, but the best you can do ex ante is estimate probabilities of those various alternatives to guide your decision.

Finally, latitude exists about when the decision can be made. You can postpone action to get more information in order to reduce--although never completely eliminate--uncertainty about the future.

The possibility of delaying an irreversible investment decision creates an option--i.e., the right, but not the obligation--to buy an asset at some future time. Analogous with options in financial assets, opportunities to acquire real assets under such flexible arrangements are sometimes called 'real options.'

Reference

Dixit, A.K. & Pindyck, R.S. (1994). Investment under uncertainty. Princeton, NJ: Princeton University Press.