759
39
Flexibility
Properly managing a modern business is about making choices to create value. 
Valuation provides important insights for executives faced with making decisions 
on corporate strategy, acquisitions and divestments, capital structure, and other 
management actions. All these decisions take place against a backdrop of uncer-
tainty about the outcomes of alternative courses of action.1 However, in some cases, 
you can face decisions where not only is uncertainty present, but so is flexibility.
Managerial flexibility and uncertainty are not the same. In cases of uncer-
tainty, the future of a company or a project may be extremely difficult to pre-
dict and depends on a single management decision—for example, to launch 
a new product line or to invest in a new production facility. Flexibility, in 
contrast, refers to choices managers may make between alternative plans in 
response to events. This is especially true when you are conducting valuations 
of investment projects.
The difference is important in deciding your approach to valuation. Whatever 
the degree of uncertainty, it is possible to value the asset in question by using 
a standard discounted-cash-flow (DCF) approach combined with either different 
scenarios or a stochastic simulation (see, for example, Chapter 17). But suppose 
management has planned to stage its investments in a business start-up. In that 
case, the managers may decide at each stage whether to proceed, depending on 
information arising from the previous stage. Where managers expect to respond 
flexibly to events, they need so-called contingent valuation approaches. These fore-
cast, implicitly or explicitly, the future free cash flows, depending on the future 
states of the world and management decisions, and then discount these to today’s 
value. For such decisions, alternative approaches provide more accurate valuation 
results and, perhaps even more important, deeper insights into what creates value.
Flexibility comes in many forms and can substantially alter the value 
of a business or project. But the business or project can have value only if 
1 See Chapters 4 and 13 for ideas on handling uncertainty, for example, with scenario-based approaches.

760  Flexibility
executives actively manage it to make better decisions. This chapter concen-
trates on the basic concepts of valuing managerial flexibility and real options 
in businesses and projects. It focuses on the following topics:
• Fundamental concepts behind uncertainty, flexibility, and value (when 
and why flexibility has value)
• Managing flexibility in terms of real options to defer investments; making 
follow-on investments; and expanding, changing, or abandoning production
• Comparison of decision tree analysis (DTA) and real-option valuation 
(ROV) to valuing flexibility, including situations in which each approach 
is more appropriate
• A four-step approach to analyzing and valuing real options, illustrated 
with numerical examples using ROV and DTA
A Hierarchy of Approaches
It is possible to illustrate a hierarchy of standard and contingent approaches to 
valuation under situations of uncertainty and flexibility and suggest when it is 
best to apply each (Exhibit 39.1). When a flexible response is neither expected 
EXHIBIT 39.1  Valuation under Uncertainty: Approaches
Single-path DCF
Probability
distribution of
path-contingent
outcomes
Outcomes
contingent on
path
Probability
distribution of
possible
outcomes
Several
possible
outcomes
Single
expected
outcome
Stochastic
simulation DCF
Decision tree
analysis (DTA)
Real-option
valuation (ROV)
Scenario DCF
Optimistic
t = 0
Base
Pessimistic
Standard Valuation
Contingent Valuation