Real Options and Strategic Investment Decisions: Can They Be of Use to Scholars?

Author(s): Charlotte Krychowski and Bertrand V. Quélin

Source: Academy of Management Perspectives, Vol. 24, No. 2 (May 2010), pp. 65-78
Published by: Academy of Management
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 2010 Krychowski ond Quelin 65

Real Options and Strategic Investment Decisions:

Can They Be of Use to Scholars?
by Charlotte Krychowski and Bertrand V. Quelin

Executive Overview
Real options (RO) analysis has been of growing interest to the academic community as a promising
approach to supporting investment decisions under uncertainty. In this article we examine an applied
investment decision in the telecommunications industry to highlight the main benefits associated with
using real options. The paper then discusses the theoretical issues raised by real options. Specifically, we
examine two research streams to explain how real options contributes to a theoretical understanding of
strategic management, and to better understand the gap between theory and practice of real options.
Finally, we lay out an agenda for future research.

The combined effects of globalization, deregula within or at the end of a fixed period ("maturity").
tion, and reduced technology cycles result in Firms establish options by making an initial in
managers facing very volatile environments in vestment, for example by performing a market
their strategic investment decisions. In spite of test, creating a joint venture, developing a proto
this ever-increasing level of uncertainty, most cor type, or purchasing an operating license (e.g., in
porations base their decisions on discounted cash the mining or telecommunications industries). If
flow (DCF)-based methods, such as the internal the economic prospects of the project turn out to
rate of return (IRR) or net present value (NPV), be favorable, a firm may later decide to exercise
which are static in nature. Indeed, these methods
the option?that is, to launch the new product, to
assume that a decision is taken once and for all,
purchase the remaining capital of the joint ven
without any possibility of modifying the charac
ture, to build a plant for the new technology, or to
teristics of the investment project later on. As a
operate the acquired license. Conversely, if eco
result, in the last decade it has been widely argued
nomic circumstances are unfavorable, it will aban
that compared with a conventional financial anal
don the option?that is, not make any subsequent
ysis, real options (RO) provides a more appropri investment.
ate framework.
The main contribution of RO is to recognize
The term "real options," coined by Myers
that investment projects can evolve over time,
(1977), corresponds to the application of financial
options theory to investment decisions made by and that this flexibility has value. Myers (1984)
firms. A financial option is the right, but not the considered that RO is a powerful approach to
obligation, to buy (or sell) a stock (the "underly reconcile strategic and financial analysis. Indeed,
conventional DCF methods often lead to recom
ing asset") at a fixed price (the "exercise price")
mendations that conflict with strategic analysis
We acknowledge the valuable comments from AMP associate editor because they fail to take into account the value of
Chung Ming Lau and two anonymous reviewers. We also thank Kevin growth opportunities created by a project.
Boudreau, Russ Coff, Rodolphe Durand, and Miige Ozman for their in
sights. Financial support and data access provided by Mobitel Company is
The RO approach has been welcomed by aca
also greatly acknowledged. demics with great enthusiasm (e.g., Bowman &
* Charlotte Krychowski (charlotte.krychowski@itsudparis.eu) is Associate Professor of Strategic Management at Telecom & Manage
ment SudParis, France.
Bertrand V. Quelin (QUELIN@hec.fr) is Professor of Strategic Management and Industrial Organization at HEC, Paris.

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 66_Academy of Management Perspectives_May
Hurry, 1993) and has led to a great deal of liter
ature on the topic. Managerial applications of RO
have been developed mainly in the petroleum
industry (e.g., Kemna, 1993; Miller & Park,
2002), the electricity industry (e.g., Leslie &
Michaels, 1997; Miller & Park, 2002; Tufano,
1996), and the pharmaceutical and biotech indus
tries (e.g., Bowman & Moskowitz, 2001). How
ever, RO has not lived up to the expectations it
raised at the end of the 1990s. Because the anal
ogy between financial options and real options is
imperfect, RO raises implementation problems,
and several surveys show that it is little used in
practice: Whereas about 75% to 85% of firms use
NPV for their investment decisions, only about
6% to 27% of them use RO1 analysis (Graham &
Harvey, 2001; Rigby ck Gillies, 2000; Ryan &
Ryan, 2002).
In this article, we use an actual decision in the
telecommunications industry to illustrate the con
cept of real options and the potential benefits of
the RO approach to improve strategic decision
making. We then draw from the case to discuss
the existing literature on real options and strategy,
and to better understand the gap between theory
and practice. Finally, we suggest avenues for future
research.
An Illustrative Case in the Mobile
Telecommunications Industry
In this section, we present an investment deci
sion and show how RO helped determine opti
mal investment timing. We then set out the
lessons learned from the case.
The Investment Decision
"Mobitel," a major telecommunications operator,
had to decide whether to deploy a third-genera
tion (3G) mobile telecommunications network.
Like its main competitor, "Comptel,"2 Mobitel
had acquired a 3G mobile telecommunications
license at a time when people had high expecta
tions of mobile Internet. However, it progressively
1 Differences in these survey findings might be due to differing inter
pretations of the term "real options." For further details, see Triantis, 2005,
p. 8.
2 These names are used to protect the anonymity of both operators.
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Table 1
Net Present Value of the Main Competitive
Scenarios Facing Mobitel (in Monetary Units)
Project Value investment
Scenario (S) Cost(Zf) NPV
1; Early entry 1386 1,280 106
2a; Late entry, preemption by Comptel 1,078 1,120 -42
2b; Late entry, no preemption 1,227 1,120 107
Average for scenario 2 1,152 1,120 32
S = Present value of cash flows generated by the 3G network;
K = present value of the investment cost to build the 3G net
work; NPV = S - K = net present value.
became apparent that 3G mobile telecommunica
tion would not be the bonanza that operators had
hoped for.
The strategic decision was whether the net
work rollout should start immediately or the de
cision to deploy the 3G network should be de
ferred by one year. MobitePs top management was
torn between the risk of investing massive sunk
costs in a technology that would not be profitable
and the risk of being preempted by its archrival,
CompteL In the case of immediate investment,
Mobitel would be ahead of Comptel, which had
announced that it would start its 3G network
deployment in six months. MobitePs operations
managers believed that the project would generate
a positive NPV of 106 monetary units (MU) (see
Scenario 1 in Table 1).
However, if the investment were delayed by
one year, Mobitel would lag six months behind
Comptel, which would entail a long-lasting de
crease in MobitePs market share. Moreover,
such a delay would lead to the loss of high-end
customers and therefore result in a significant
reduction in the average revenue per unit
(ARPU). As a result, the project's NPV would
become negative, falling to -42 MU (see Sce
nario 2a in Table 1).
Alternatively, if Mobitel postponed its deploy
ment by one year, Comptel could well do the
same. In such a case, Comptel would let Mobitel
test the waters and follow suit six months later.
The NPV of the 3G network would then be 107
MU, nearly the same project value as that ob
tained if Mobitel launched the investment imme
diately (see Scenario 2b in Table 1). If we assume
 2010
a 50% probability of preemption, the revised NPV
of the late-entry scenario amounts to 32 MIL
However, this value remains lower than the NPV
of the early-entry scenario.
The point raised by MobitePs finance team was
that the project's profitability was subject to a
great deal of uncertainty concerning the level of
demand. The decision took place at a time when
the speed of penetration of the 3G technology was
uncertain because the market was not yet mature.
Similarly, the ARPU generated by a 3G network
was very uncertain. In particular, data ARPU
could remain low if consumers used mobile Inter
net applications only occasionally or used primar
ily low-bandwidth applications.
A sensitivity analysis showed that, depending
on the value given to these two sources of uncer
tainty, the NPV of the 3G project could vary
greatly, between -600 and +500 MU. Given the
high uncertainty surrounding the success of the
3G technology and the irreversibility of the in
vestment in a new network, the Mobitel finance
managers were in favor of deferring the rollout
decision.
The RO Framework to Determine Optimal Entry
Timing
Choosing the right market entry timing of a new
technology is difficult because it involves making
a trade-off between commitment and flexibility
(Ghemawat, 1991). Past studies do not provide a
decisive answer to this dilemma. For example,
first-mover advantages may be counterbalanced
by first-mover disadvantages (Lieberman & Mont
gomery, 1998). From an organizational learning
perspective, it can be argued that firms investing
early in promising technologies increase their ab
sorptive capacity (Cohen & Levinthal, 1990) and
are later much better positioned than competitors
to take advantage of the new technology (e.g.,
3G) once it becomes clearly established on the
market. But again, this line of reasoning can be
altered by several contextual factors, such as the
intergenerational spillovers (Leiblein & Ziedo
nis, 2007), which were significant for the mi
gration from 2G to 3G mobile telecommunica
tion networks.
Given this complexity and the high level of
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Krychowski and Quelin 67
uncertainty, decisions on the early adoption of
innovation may lead to mimetic processes, induc
ing firms to make similar choices (DiMaggio &
Powell, 1983). In the Mobitel case, the uncer
tainty regarding the success of 3G clearly resulted
in pressure being placed on the operational team
to conform to the strategy announced by their
main competitor. As such isomorphic behavior
can have a negative impact on profitability (e.g.,
Barreto & Baden-Fuller, 2006), it is of particular
interest to focus on a framework such as real
options, which holds the promise of a more disci
plined decision process.
Financial option models provide analysts with
two types of information at the same time: (a) the
option value and (b) the most optimal time to
exercise the option. Similarly, RO is useful both
to evaluate an investment project and to deter
mine the optimal investment timing.
The decision faced by Mobitel can be ana
lyzed with an options lens because the operator
had some flexibility if it chose to postpone the
network rollout by one year. Indeed, if at
the later date the case for 3G has improved, the
operator will deploy the 3G network. If, to the
contrary, 3G does not appear to be profitable in
one year, Mobitel could instead invest in the
alternative technology EDGE, which is slightly
less powerful but much less costly to deploy
than 3G. In other words, Mobitel held an op
tion to wait. Exercising the option meant de
ploying the 3G network. The underlying asset S
corresponds to the cash flows generated by the
network. The exercise price K corresponds to
the investment cost of rolling out the new net
work. The time to maturity T is one year: Be
yond this date, the operator would have to
invest in order to address its network's looming
capacity shortage.
As a consequence, the late-entry scenario can
be valued as an option to defer. The option can be
valued with the Black-Scholes formula, which is
the standard model used to evaluate simple op
tions (see Table 2). We thus come up with a
revised project value of 139 MU in the case of late
market entry. This value is higher than that of the
early-entry scenario (106 MU), which suggests
68 Acodemy of Management Perspectives May

Table 2
Valuation off the Option to Defer With the Bla<k-S<holes Formula
Parameter of a Financial Option
Value Application to MobitePs Investment Project Value in Monetary Units (MU)
Underlying asset (stock) price (S) Cash flows generated by the 3G network 50o/o*1,078 + 50?/o*1,227 = 1,152 MU

Exercise price (/Q Investment cost necessary to deploy a 3G network 1,120 MU

Time to expiration!?) Period during which the investment can be postponed 1 year

Risk-free rate interest (r) Risk-free interest rate 5% p.a. (based on interest rate of Treasury bills)

Volatility of the underlying asset (a) | Volatility of the cash flows generated by the 3G network 20% (estimated with Monte Carlo simulations on 5)
Value of the option to defer (C): C = S * N{d,) - K e"rT * N{d2), where
d: = [In S/K + (r + <j72) * TVa^f
d2 = di ? (Tyjf
N(.) = cumulative standard normal distribution function
C= 139 MU

that, according to RO, it would have been pref
erable to postpone the investment decision.
Lessons Learned From the Mobitel Case
The Mobitel case highlights three main benefits
of RO analysis (see Table 3).
An Informed Decision on Optimal Investment Timing
In the Mobitel case, RO analysis produced the
opposite recommendation on investment timing
(delay the investment decision) as the NPV did
(invest now). The NPV rule is biased in favor of
early market entry because it takes into account
The outcome of the managerial decision mak
ing confirms that this flexibility has value: In spite
of the recommendation of an early market entry
produced by the NPV calculation, MobitePs se
nior management decided to postpone the rollout
of the 3G network until there were more clear
signs that the technology would be profitable.
Eventually, the operator deployed 3G in the most
densely populated areas and EDGE in the rest of
the territory. Thus, Mobitel took full advantage of
the flexibility offered by waiting.
A Helpful Tool for Dialogue Among Decision Makers

the risk of waiting (preemption) but not the re
wards of waiting (reduced uncertainty). NPV does
not capture the value of staying flexible, and
hence offers little guidance on optimal market
entry timing. In contrast, RO explicitly incorpo
rates uncertainty and the possibility of modifying
the investment decision based on the value taken
by uncertain variables.
Table 3
Summary of Benefits of Real Option Analysis in the Mobitel Case
Situation at Mobitel
Strategic decision making often involves many peo
ple and groups pursuing divergent interests (Astley,
Axelsson, Butler, Hickson, & Wilson, 1982). At
Mobitel, it was difficult to establish a dialogue be
tween the business unit and the finance department
on the 3G network rollout issue. Yet, a successful
strategy emerges from decision processes that take
into account different viewpoints (Eisenhardt,
Potential Benefits of RO

Valuation Network rollout delayed, although NPV analysis Informed decision on investment timing (ability to balance
recommended immediate launch
the risks and rewards of delaying market entry)_
Communication Disagreement between the business unit and the Improved dialogue between the various project stakeholders
finance department_
Decision Process Attention focused on the 3G project Greater ability to abandon the project if signs of failure
No real interest paid to alternative technical solutions multiply
Enhanced reactivity to launch an alternative project in
case of failure

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 2010
1999). RO has the advantage of incorporating
within one single approach the various concerns
expressed by the stakeholders. The approach does
not eliminate any uncertainty regarding the success
of the new technology or the strategy followed by
the main competitor. Nevertheless, it provides the
management with a framework in which hypotheses
can be discussed and their impact measured through
a sensitivity analysis.
A More Efficient Decision Process
Cognitive biases can prompt management to pur
sue an investment in spite of negative feedback
(Kahneman, Slovik, & Tversky, 1982). In partic
ular, the sunk cost effect refers to the tendency for
decision makers to pursue projects in which they
have made substantial prior investment. At Mo
bitel, huge sums had already been invested in the
3G license, and we observed that the analysis
concentrated on the 3G scenario alone, as if there
were no alternative solutions.
This type of antifailure bias can be addressed
through real options reasoning (McGrath,
1999). RO prompts top management to seri
ously consider alternative scenarios from the
outset, and to stop projects when signs of failure
multiply. In MobitePs case, RO suggested pay
ing greater attention to alternative migration
paths, such as deploying EDGE instead of 3G
and then leapfrogging to 3.5G. If 3G were aban
doned, Mobitel would then be better prepared
to quickly redirect resources to these alternative
technologies.
Theoretical and Research Implications
The Mobitel example highlights several ways in
which RO can improve the strategic decision
process under uncertainty. Has this been con
firmed by the existing literature, and if so, why do
more firms not use this framework? We will next
review some of the major domains that have em
ployed RO in strategic decisions. We organize the
key findings and debates in the RO literature
along two main perspectives: as an interpretative
lens and as a decision framework.
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Krychowski and Quelin 69
Real Options as an Interpretative Lens
As an interpretative lens, RO can help analyze
firms' investment choices and their performance.
The contribution of RO to each of these domains
will be examined in turn.
Firms' Investment Choices
One of the areas in which RO has proved to be a
useful theoretical perspective as an interpretative
lens is related to choices for market entry invest
ments. Firms contemplating entry into a new mar
ket can defer investment until the uncertainty is
reduced. The value of this option to defer in
creases with uncertainty, which implies that the
greater the uncertainty, the more firms will tend
to postpone investment in the new market. How
ever, RO takes into consideration that even if the
initial investments are not profitable, they will
provide firms with new capabilities (e.g., knowl
edge of a developing country) that will enable
them to seize future opportunities (Kogut & Ku
latilaka, 2004; Vassolo, Anand, & Folta, 2004).
This tension between the option to defer and the
option to grow explains why the effect of uncer
tainty on market entry is nonmonotonic (Folta &
O'Brien, 2004).
Another type of investment choice that fits
well with the real options logic is research and
development (R&D) and, more generally, high
technology investment decisions. Indeed, these
decisions are taken in a context of a high level of
uncertainty and can be managed in a flexible way
because the investment process is sequenced in
different phases. For example, the analysis of pat
ents by firms active in the pharmaceutical industry
shows that their investments in R&D are consis
tent with the RO logic (McGrath & Nerkar,
2004). It appears, though, that not all firms are
equal in their ability to create and exploit these
options. While Japanese high-technology venture
capitalists implicitly follow a real options logic,
whereby initial investments in high-tech research
are followed by a full-scale investment when the
benefits of the new technology appear realizable,
their American counterparts seem to follow an
"all or nothing" strategy (Hurry, Miller, & Bow
man, 1992).
 70_Academy of Management Perspectives_ May
The literature has also used RO to better un
derstand the structuring of investment choices.
There is now a vast amount of literature analyzing
governance choices with an options lens, often in
combination with transaction costs economics
(TCE) or the resource-based view. More precisely,
scholars have built on Kogut's (1991) research
demonstrating that firms investing in a joint ven
ture (JV) acquire the option to buy the partner's
stake if the firm considers it profitable to expand
its activity in this sector. As option value in
creases with the level of uncertainty, a high level
of uncertainty will lead firms to choose JVs as a
mode of market entry rather than wholly owned
subsidiaries, which are much less flexible. Thus,
under certain conditions, RO theory comes up
with a prediction that is the opposite of that
provided by the transaction costs theory. Indeed,
TCE claims that in order to avoid opportunistic
behavior from the partner, the wholly owned sub
sidiary is preferable to the JV in case of high
uncertainty (Chi & Seth, 2009). However, it ap
pears that only exogenous uncertainty on which
the firm has no influence, such as macroeconomic
conditions in a foreign country, can explain the
tainty, there is no simple relationship between the
establishment of JVs with a real options logic,
market value of R&D and the level of uncertainty.
whereas endogenous sources of uncertainty, such
as cultural uncertainty, do not have the impact
predicted by RO theory (Cuypers & Martin,
2010).
Performance Outcomes of Real Options
RO has also been useful in examining the link
between firms' performance and the presence of
options within those firms (Tong & Reuer,
2007b). One of the main issues that has been
investigated is whether firms actually capture
the value of real options, and if so, under what
conditions.
Kester (1984) measured the value of growth
options as the difference between the total mar
ket value of a company's equity and the capi
talized value of its current earning stream. He
found that growth options constitute well over
half the market value of many companies' eq
uity. However, the proportion of the growth
options' value is much higher for firms operat
ing in high-technology industries than for other
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firms. Using a more sophisticated way of mea
suring growth options' value (with Stern Stew
art's Market Value Added database) on a larger
sample, Tong, Reuer, and Peng (2008) broadly
confirmed Kester's conclusions.
Breaking down the option value component in
the value of firms and identifying which types of
investments create option value is a challenging
task. More specifically, researchers have at
tempted to analyze the impact of JVs and R&D
investment on options value. The study by Tong
et al. (2008) showed that not all international JVs
(IJVs) create option value. For example, IJVs in
emerging economies do not create growth option
value, probably because of the high transaction
costs associated with the management of this
option.
Similarly, Oriani and Sobrero (2008) analyzed
the market value of R&D investments, which are
affected by three intertwined real options: the
option to grow, the option to defer (further R&D
investment), and the option to switch (to another
technology). While option theory claims that the
option value increases with the level of uncer
Indeed, technological and market uncertainty
have different effect s on the three types of options
created by R&D. The bottom line is that we can
observe a U-shaped relationship between market
uncertainty and the market value of R&D, and an
inverted U-shaped relationship between technolog
ical uncertainty and the market value of R&D.
Real options not only enable firms to capture
the value of growth opportunities in case of favor
able circumstances; they also limit the downside
risks in case of unfavorable conditions. In practice
though, the literature again highlights the com
plexity of the relationship between the presence
of options and the downside risk supported by
firms. For example, multinational enterprises,
which have an option to switch activities between
countries, should have a lower exposure to inter
national economic changes, such as exchange rate
fluctuations. Empirical studies show that the rela
tionship between multinationality and downside
risk is curvilinear, whereby risk first declines and
 2010_Krychowski and Quelin_711
then increases beyond a certain point of interna
tional expansion (Tong & Reuer, 2007a).
Real Options as a Decision Framework
The second main stream of literature employing
the perspective of RO concerns decision frame
works in which RO is employed to help firms
evaluate and structure strategic investment oppor
tunities under uncertainty. It highlights two main
possible roles for RO in strategic decision making:
real option valuation and real option reasoning.
Real Option Valuation
In the economic and financial fields, scholars fo
cus on real option valuation. The pioneering val
uation models have shown that in a context of
uncertainty RO may produce more appropriate
capital budgeting recommendations than the
NPV rule (e.g., Brennan & Schwartz, 1985; Majd
& Pindyck, 1987; McDonald & Siegel, 1986).
The literature now offers a large number of
increasingly complex real option valuation
models, some of which have also become more
sophisticated with the integration of competi
tive forces. The first real option model in a
duopoly was developed by Dixit and Pindyck
(1994) and opened a growing literature stream
combining real options and game theory (see
Smit and Trigeogis, 2006, for a review of the
literature on this subject).
Overall, these models lack practical imple
mentability (Triantis, 2005). They are mathemat
ically opaque and usually rely on restrictive hy
potheses, which may be barely compatible with
real-life investments. However, some rare empir
ical studies suggest that valuations calculated with
real options models are consistent with empirical
data and with investment decisions made by firms:
Quigg (1993) in the real estate sector, and Har
chaoui and Lasserre (2001) as well as Moel and
Tufano (2002) in the mining industry.
Real Option Reasoning
In the strategic management field, the literature
concentrates on RO as a way of thinking. Many
researchers (e.g., Coff & Laverty, 2001; Miller &
Waller, 2003; Sharp, 1991) are aware of the dif
ficulties of translating financial option theory to
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real investment decisions (Kogut & Kulatilaka,
2004) and of valuing real options. Therefore, they
believe that RO should instead be used as a rhe
torical tool
There are several ways in which real option
reasoning can help organizations better structure
their investment decisions in a context of high
uncertainty. First, RO can induce firms to under
take risky projects, as option value increases with
volatility (McGrath, 1999). Second, RO recom
mends that investments be sequenced in several
phases, in order to take advantage of upside risk
without bearing the cost of downside risk (Leslie
& Michaels, 1997)* Last, RO prompts manage
ment to pilot projects in a proactive way. Firms
tend to suffer from inertia in their management of
projects (e.g., Busby & Pitts, 1997). One benefit
of RO is to encourage management to preserve
flexibility of choice and to modify the investment
project according to economic circumstances
(McGrath, Ferrier, & Mendelow, 2004).
More recently, the literature has warned about
the limits of RO. These include three main short
comings: (a) the framework does not apply to all
investment decisions, (b) it raises serious imple
mentation issues, and (c) it does not take into
account behavioral and organizational biases. Be
low we will examine each of these in more detail.
Application Domain. Not all investment decisions can
be framed as options. Four main conditions have
to be fulfilled in order for a decision to be appro
priate for real option logic: irreversibility, uncer
tainty, flexibility, and information revelation. In
case of low degree of uncertainty and irreversibil
ity, the NPV rule is more appropriate than RO
(Adner & Levinthal, 2004). Flexibility means
that when the option expires, the firm really has
the possibility to choose among several alterna
tives. In the Mobitel case, an alternative to 3G
was to invest in the EDGE technology. If there is
no other viable alternative, the investment
project is a "bet," not an option (Copeland &
Keenan, 1998). On the other hand, if the scope of
opportunities is too wide (either from a techno
logical or from a market perspective), the decision
process is more characterized by path dependence
than by the option logic. Whereas the RO ap
 72_Academy of Management Perspectives_ May
proach requires specifying ex ante the possible
project scenarios, exploration activities are diffi
cult to anticipate. The risk of using RO in such
contexts is to abandon a project that does not
fulfill the rigid RO criteria, even if this project
introduces unanticipated promising possibilities
(Adner & Levinthal, 2004).
Finally, the condition of information revela
tion refers to the possibility of reducing uncer
tainty during the life of the option, either by
observation or by investing in information acqui
sition. However, there are projects for which the
value of the underlying asset cannot be known at
exercise time?for example, in case of a disruptive
technology, of strong network externalities, or of
knowledge-based assets, whose value is particu
larly difficult to analyze (Woiceshyn & Falken
berg, 2008). As a result, managers may errone
ously drop options that would lead to a
competitive advantage or conversely invest in the
wrong project (Cofif & Laverty, 2001).
Implementation Issues. The identification and the val
uation of real options both raise difficulties.
Whereas financial options are formalized by a
contract, real options are "part and parcel of the
business" (Myers, 1996, p. 100). As a conse
quence, it is difficult for managers to identify the
latent "shadow options" within their firms (Bow
man & Hurry, 1993). Valuing real options is also
a challenging task. The option theory has devel
oped a vast variety of option valuation models,
which rely on a number of implicit hypotheses
and can lead to different results (Borison, 2005).
Managers?and even many academics?do not
have the mathematical skills necessary to use real
option valuation models comfortably and knowl
edgeably (Lander & Pinches, 1998). Even if a
model seems simple in use, it is important to
understand the hypotheses behind it to avoid er
roneous conclusions, as was shown by Bowman
and Moskowitz (2001) with the example of
Merck. For more complex investment decisions, it
is also necessary to adapt standard valuation mod
els to the specificities of the investment project.
Again, this requires mathematical skills that are
often beyond the capabilities of corporate manag
ers (Bowman & Moskowitz, 2001).
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Behavioral and Organizational Biases. RO rests on the
assumption that managers will follow a strict op
tional discipline, from the project inception to its
implementation or abandonment. The RO ap
proach consists of starting a lot of projects, but
also of ruthlessly abandoning options that do not
live up to expectations (McGrath, 1999). How
ever, unlike financial options, real options do not
have a clear expiration date. As the project's
champions can claim that an apparently failing
project will produce valuable opportunities in the
future, escalation of commitment may occur, en
tailing the multiplication of losses (Adner &
Levinthal, 2004; Jartney & Dess, 2004). The ques
tion is then whether firms are capable of putting
in place the appropriate organizational mecha
nisms to ensure an effective management of real
options (McGrath, Ferrier, & Mendelow, 2004).
Empirical Evidence
Empirical studies on the implementation of RO
are still rare (on this subject see, e.g., Tong and
Reuer, 2007b), and research remains relatively
silent on how to concretely apply RO theory. Yet,
a few case studies inspired by real investment
decisions underline the benefits of RO for strate
gic decision making and illustrate the wide range
of potential applications of RO. In capital-inten
sive industries such as the petroleum industry,
which are comfortable with sophisticated capital
budgeting decision tools, real options are evalu
ated with complex models, often in combination
with decision analysis approaches (e.g., Chorn &
Shokor, 2006; Smith & McCardle, 1999), in order
to make decisions on exploration investment
projects.
In other industries, case studies demonstrate
that RO can be particularly useful in determining
the optimal investment timing?for example, for
the market introduction of a new product in con
sumer electronics (Pennings & Lint, 2000), for
the deployment of a new banking IT system
(Benaroch & Kauffman, 1999), or for the devel
opment of residential housing (Rocha, Salles, &
Garcia, 2007). In other instances, real options are
used to evaluate an investment under uncertainty,
such as the investment in a software platform
(Taudes, Feurstein, & Mild, 2000), in environ
 2010
mental mining equipment (Cortazar, Schwartz, &
Salinas, 1998), or in an R&D project (Pennings &
Lint, 1997).
Overall, existing empirical studies provide lim
ited evidence of the benefits of RO in the resource
allocation process. Indeed, they do not reflect the
practice of firms, but are rather the result of pilot
projects on the use of RO. In addition, case studies
mainly focus on the valuation aspect of RO; they
tend to overlook the benefits of real options rea
soning and leave unexplored the cognitive and
organizational difficulties in the implementation
of RO.
Future Research
In spite of its surge in publications, RO theory
remains a relatively young field of research, of
which only a small portion speaks directly to
managers. In the following section we suggest re
search directions that will help to further the use
of RO theory.
Exploiting the Descriptive Power of Real Options:
The "Telescope Dilemma"
The main contribution of RO theory in the inter
pretative lens perspective is to shed new light on
the consequences of uncertainty, which is one of
the five key concepts structuring research in stra
tegic management (Rumelt, Schendel, & Teece,
1994). A central proposition in RO theory is that
the option value increases with the level of un
certainty, just as the value of a financial option
increases with the volatility of the underlying
asset. As a consequence, RO theory shows that
firms can take advantage of uncertainty rather
than trying to avoid it. The options lens thus
provides new insights into issues such as the op
timal governance mode and the link between un
certainty and the level of investments.
In addition, RO theory contributes to a better
understanding of the impact of firms' decisions on
their performance. Other theories may fail to
demonstrate the link between certain decisions
and firms' performance, because they look at the
aggregated value of the firm, whereas these deci
sions may have an impact only on the option
value of the firm and not on the value of assets in
place, or vice versa. To illustrate, Tong et al.
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Krychowski and Quelin 73
(2008, p. 1024) explained that existing studies
came up with contradictory results on the perfor
mance impact of diversifying versus nondiversify
ing JVs. The contradiction could be reconciled by
taking into consideration that diversifying JVs has
a positive impact on the growth option value of a
firm, as opposed to its total value.
Overall, the literature on real options has sig
nificantly contributed to a better understanding of
the behavior and performance of firms. However,
real options have mostly been used in a very
metaphorical way, and existing empirical studies
do not provide direct evidence that decisions
made by firms were guided by RO logic (Reuer &
Tong, 2007).
Scholars studying RO face the same dilemma as
astronomers, who have to make a choice between
using small telescopes that can see a large portion
of the universe but cannot detect weak signals and
large telescopes that are much more powerful but
have a narrow focus. In other words, many issues
can be analyzed with an options lens, but when
researchers apply this framework to broad and
general issues they cannot exploit the "power" of
the theory.
Future research should attempt to analyze more
focused issues. First, this would reduce the diffi
culty of analyzing decisions that involve several
intertwined options. Second, conducting studies
in specific settings would enable scholars to model
the impact of the main variables that affect option
value instead of testing the effect of broad vari
ables that provide only indirect evidence of the
options perspective.
As outlined in the Mobitel case, the option's
value depends on five main parameters: S, K, r, cr,
T (see Table 2). The uncertainty parameter cr,
which is central to the options theory, should be
studied in great detail, because the various sources
of uncertainty have a different impact?or no
impact at all?on an option's value. Interesting
studies could also be conducted by analyzing sim
ilar decisions that have a different time to matu
rity (T). Similarly, it would be interesting to study
to what extent the difference between the under
lying asset value (S) and the exercise price (K)
affects an investment decision based on real op
tions logic. For example, JVs offering the possibil
 74_Academy of Management Perspectives_May
ity to purchase equity from a partner at a prespeci
fied price should provide firms with a potentially
higher payoff than JVs where the partner's stake is
purchased at fair market value.
Another variable that is often overlooked in
the real options literature is the dividend rate
(S)3. In finance, because the payment of the div
idend reduces the underlying asset value, it may be
optimal to exercise the option, even if the date to
maturity has not been reached. In the corporate
world, the dividend rate corresponds to the cost of
keeping the option alive. Taking this parameter
into consideration would enable researchers to
better understand why it is not always optimal to
"keep options open" and come up with less intu
itive results.
Developing the Normative Aspirations off Real
Options Theory
Another critical contribution that has been high
lighted in the existing literature is the normative
benefits of RO. However, the limits of RO as a
strategic decision tool have also been recognized.
Future research will have to better understand if
and to what extent aligning corporate decision
processes with real option logic may affect com
petitive advantage. This can be addressed through
two main questions: (a) what is the application
domain of RO, and what type of RO analysis
should be conducted depending on the project
characteristics?, and (b) under what conditions
can firms achieve a successful implementation of
RO? These two questions and the future research
needed to answer them are addressed below.
Application Domain of RO Analysis
Corporate applications and academic research
have concentrated on specific decisions in a lim
ited number of industries. At the same time, the
actual debate among scholars on the situations in
which RO can be applied has been limited to very
general and theoretical considerations. Research
now needs to study in greater detail for which
types of decisions RO analysis is beneficial. In so
3 This parameter does not appear in Table 2, because the standard
Black-Scholes formula calculates the value of a European option on an
underlying asset that does not pay any dividend.
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doing, it is important to keep in mind that there is
no clear distinction between projects that fit well
with the RO logic and those that do not. Rather,
an interesting research avenue would be to deter
mine which type of RO analysis should be applied,
depending on the project's characteristics and on
the level of analysis (one project versus a portfolio
of projects or the entire firm).
The "telescope" metaphor is also applicable
to the normative perspective of RO: At one end of
the spectrum, RO can be applied in a formal and
quantitative way in order to make decisions on
focused investment projects for which the main
sources of uncertainty can be modeled. At the
other end of the spectrum, RO can also be applied
to broad and complex issues involving interdepen
dent projects and options and covering a long
time horizon, but in this case only a rhetorical use
of RO will be possible. As a matter of fact, Triantis
(2005) reported that some firms use RO as a way
of thinking, whereas others apply formal, quanti
tative RO valuation models. Future research
should further develop the understanding of the
uses and limits of RO in each of these different
settings. The RO method employed in one setting
may be inappropriate in another.
Conditions for a Successful Implementation of RO
Concerning RO valuation, research needs to
move from rigid financial models to flexible and
simple heuristic methods that can be more easily
implemented. There is some potential for simpli
fying the computational side of real options, in
particular by using more intuitive simulation
based methods. Similarly, future research on RO
will have to shift from a "financial" to a "strategic"
perspective and pay much greater attention to the
behavioral and organizational constraints in the
use of RO analysis. Like game theory, RO theory
is grounded on a hyper-rational vision of the de
cision process, and on the capacity of agents to
model uncertainty and its consequences. This
contrasts sharply with many theories used in stra
tegic management, such as organizational learning
theory and institutional theory, that assume
bounded rationality and significant difficulties in
modeling uncertainty.
Future research will have to incorporate a per
 2010
spective of how managers make decisions in light
of their options (Barnett, 2008). Of particular
interest would be to study the organizational
mechanisms that are necessary to capture the full
benefits of the real options approach. These in
clude organizational structure, incentives for man
agement, and allocation of decision rights.
In terms of methodology there is a clear need
for more empirical research on the conditions for
successful implementation of RO. In particular,
conducting detailed, longitudinal case studies, as
is common in the strategic investment decision
literature (e.g., Bower, 1970), would greatly ad
vance RO research. Whereas the RO literature
has concentrated on the initial investment deci
sion, the Mobitel case has shown that RO may
contribute to improving the decision-making pro
cess during the entire life of the project. Conduct
ing in-depth case studies would enable researchers
to understand how RO can improve the strategic
decision process from project inception to termi
nation, and to test whether, and under what con
ditions, managers are capable of sticking to the
optional discipline. However, this will be a chal
lenging task, since few firms currently use RO
analysis.
Building Bridges Between the Various RO
Research Streams
The RO literature is marked by the lack of con
nections among the various subfields, and estab
lishing bridges between them would advance RO
theory. In particular, connecting the descriptive
and normative perspectives plus integrating the
qualitative and quantitative approaches would be
valuable for RO.
Reconciling the Descriptive and Normative Perspectives
Research generally involves a balance between a
descriptive and a normative perspective, and RO
theory is no exception. Myers, the "inventor" of
real options, actually used this concept both as an
explanatory framework to better understand cor
porate borrowing behavior (Myers, 1977) and as a
normative decision tool bridging corporate fi
nance and strategy (Myers, 1984). The interpre
tative lens and decision framework streams have
evolved independently, whereas they ought to en
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Krychowski and Quelin 75
rich each other: Research on how firms actually
make decisions should be used to validate and
refine hypotheses of RO valuation models, as is
suggested by Cuypers and Martin (2010) for gov
ernance choices. Conversely, research on the con
ditions under which RO can be used as a decision
framework by firms can help scholars analyze the
performance implications of RO.
It will be a challenge to reconcile the descrip
tive and normative perspectives, as they rest on
seemingly contradictory hypotheses: The interpre
tative lens stream makes the implicit assumption
that firms intuitively use RO. In contrast, the
decision framework stream implicitly hypothesizes
that only firms capable of acquiring real options
and properly managing them will achieve superior
performance. Nevertheless, the Mobitel example
suggests that a formalized RO analysis can be
beneficial, even if the RO logic is intuitively used
by the management: On one hand, Mobitel man
agement intuitively pursued an RO logic, as they
decided to wait in spite of a positive NPV. On the
other hand, a formal use of RO analysis would
probably have enabled a much smoother, more
disciplined, and more reactive decision process.
Reconciling the Qualitative and Quantitative Approaches
Within the decision framework stream, there is
again an apparent contradiction between the "real
option valuation" and the "real option reasoning"
approaches. The qualitative use of RO should not
be understated. Indeed, empirical research has
demonstrated that, in practice, the quantitative
evaluation of a project plays only a limited role in
strategic investment decisions, and that manage
ment gives an equal, if not greater, importance to
strategic considerations emerging from informal
processes (e.g., Arnold & Hatzopoulos, 2000; But
ler, Davies, Pike, & Sharp, 1991).
At the same time, if we do not attempt to
evaluate real options, there is the risk that RO
could be perceived as a tool used to justify launch
ing projects whose NPV is negative, or keeping
alive projects that are not succeeding. A purely
rhetorical use of RO presents two additional dis
advantages. First, relying on an intuitive estima
tion of option value can be dangerous, as past
research has shown that managers' intuition is not
 76_Academy of Management Perspectives_May
necessarily in line with the value produced by RO
theory (Howell & Jagle, 1997; Miller & Shapira,
2004). Second, flexibility usually comes at a cost.
It is therefore often necessary to value the option
in order to assess whether the benefit of flexibility
exceeds its cost.
The field experience at Mobitel suggests that
we should go beyond the "quantitative versus
qualitative" debate. Because a strategic invest
ment decision is so complex, the result of the
option valuation should be taken with circum
spection. The option value per se is only one of
several elements affecting the decision. Qualita
tive findings from RO can also play a key role in
the decision-making process. Conversely, an RO
that would be based only on qualitative analysis,
without attempting to value the real option(s)
embedded in the investment decision, would be
limited to superficial conclusions. Qualitative
findings from RO emerge only when a detailed,
quantitative analysis is performed: This prompts
management to be more explicit about key as
sumptions (e.g., the success of 3G), and to manage
the investment project proactively.
Conclusion
Overall, this article has shown not only the
practical use of RO theory but also the cur
rent gaping holes in its use. In particular, we
believe that scholars should attempt to establish
linkages between the various streams of the RO
literature: Future research would benefit from in
tegrating the explanatory and the normative per
spectives of RO theory as well as connecting the
qualitative and quantitative approaches of RO.
There is also a clear need for more empirical
research that directly demonstrates the relevance
of the RO perspective to explain firms' behavior
and identifies clearly the benefits of RO to the
resource allocation process. It is hoped that this
manuscript generates both discussion among aca
demics and further use of this theory in future
strategy research.
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