What is real option analysis? How is it a better method of making investment decisions than using traditional capital budgeting analysis?

What will be an ideal response?

Answer: Real options is a different way of thinking about investment values. At its core, it is a cross between decision-tree analysis and pure option-based valuation. It is particularly useful when analyzing investment projects that will follow very different value paths at decision points in time where management decisions are made regarding project pursuit. This wide range of potential outcomes is at the heart of real option theory. Real option valuation also allows us to analyze a number of managerial decisions that in practice characterize many major capital investment projects:
1. The option to defer
2. The option to abandon
3. The option to alter capacity
4. The option to start up or shut down (switching)

Real option analysis treats cash flows in terms of future value in a positive sense, whereas DCF treats future cash flows negatively (on a discounted basis). Real option analysis is a particularly powerful device when addressing potential investment projects with extremely long life spans or investments that do not commence until future dates.
Real option analysis acknowledges the way information is gathered over time to support decision-making. Management learns from both active (searching it out) and passive (observing market conditions) knowledge-gathering and then uses this knowledge to make better decisions.