Real Options and Rules of Thumb in Capital Budgeting

Most firms do not make explicit use of real option techniques in evaluating investments. Nevertheless, real option considerations can be a significant component of value, and firms which approximately take them into account should outperform firms which do not. This paper asks whether the use of seemingly arbitrary investment criteria, such as hurdle rates and profitability indexes, can proxy for the use of more sophisticated real options calculation. We find that for a variety of parameters, particular hurdle rate and profitability index rules can provide close-to-optimal investment decisions. This suggests that firms using seemingly arbitrary "rules of thumb" may be trying to approximate optimal decisions.