7 A Review of Real Option Practices Followed by Corporate for Expansion and Deferral Decision A Review of Real Option Practices Followed by Corporate for Expansion and Deferral Decision Urvashi Varma* © 2011 IUP. All Rights Reserved. Real option is synonymous with financial flexibility. Traditional valuation has always ignored this flexibility and has provided inappropriate estimate of the projects for decisions. This paper tries to capture different types of real options and their valuations. The Black-Scholes model as suggested by many researchers can be applied only to European option, but in this paper studies that have valued American option using Black-Scholes approach with slight modification are also found. The binomial lattice model is an alternative to value American option, but to avoid complexity binomial tree is more preferred. Given the priori probabilities, decision tree approach provides a simplistic method to value real options. * Lecturer in Finance, BLS Institute of Management, Mohan Nagar, Ghaziabad, Uttar Pradesh, India. E-mail: urvashi23varma@gmail.com Introduction The valuation of a project is traditionally done using the Discounted Cash Flow (DCF) technique. The Net Present Value (NPV) approach incorporates studying the present value of cash inflows less the present value of cash outflows. NPV advocates accepting the project when NPV has a positive value and rejecting it when the calculated value is negative. The decisions made at the corporate level are not this simple. For example, investment in a new technology does not just depend on its payoff and cost. It is affected by other factors, like under which period of time the technology is adopted, what is the risk of obsolescence of this technology, does this technology provide a platform for further upgradation and so on. Therefore, in traditional valuation we are missing on the flexibility associated with the investment opportunity. This flexibility adds value to the project and increases its chances of being accepted (Kemma, 1993). These flexibilities associated with the projects are referred to as real options associated with that particular decision. The term ‘real options’ was coined by Stewart C Myers in 1977. As time progresses the uncertainty about an investment reduces with availability of new information. An investment that is initially not lucrative based on traditional valuation techniques may turn out to be favorable after the onset of new information. The benefits of using real options are in terms of managerial flexibility. Hence, the use of option pricing theory to value the complex investment decisions has found a sustainable ground. There are situations in which a particular investment creates a platform for follow-up investment in future. The success of a particular stage depends on the