Explanation

Correct Answer: B

When evaluating a project with a real option, the proper approach is to include the value of the real option in the project's net present value (NPV) calculation. However, this value should be net of any incremental costs associated with obtaining or exercising the real option.

Why Option B is correct:

1. Real options (such as the option to expand, abandon, delay, or switch) have value that should be incorporated into project evaluation.
2. The value of a real option is typically calculated using option pricing models (like the Black-Scholes model or binomial models).
3. Any incremental costs required to obtain or exercise the option should be subtracted from the option's value.
4. The resulting net value should then be added to the traditional NPV calculation.

Why Option A is incorrect:

• The cost of a real option is not necessarily a sunk cost. Sunk costs are costs that have already been incurred and cannot be recovered, regardless of future decisions. The cost of obtaining a real option may be an incremental cost that should be considered in the analysis.

Why Option C is incorrect:

• Even if a project has a negative NPV before considering real options, the value of embedded real options might make the overall project value positive. Management should consider the total project value including real options before making a decision.

Key Concept: Real options analysis recognizes that management has flexibility to make future decisions that can enhance a project's value. This flexibility has economic value that should be quantified and included in capital budgeting decisions.