Real options and public sector capital project decision-making

Capital budgeting decisions are among the most important decisions that a public financial manager makes. The traditional methodology for determining whether or not such an investment should be made is known as the discounted cash flow method. This method, unfortunately, does not capture efficiently the benefits of flexibility that often accompany capital budgeting decisions. This paper discusses the concept of real options and how the public sector managers can employ this relatively new technique to better value their capital budgeting opportunities. We argue, both through financial theory and through examples, that employing real option modeling in public sector capital decision-making will improve the efficacy of capital budgeting decisions.