Real Option Method and Escalation of Commitment in the Evaluation of Investment Projects

Abstract

Problem statement: This study applies an experimental method to find out whether using the real option method along with the discounted cash flow techniques can reduce the decision-makers’ Escalation of Commitment (EC hereafter) or their desire to keep up their commitment to a failed project. Approach: The real option method used for the evaluation of long-term projects also measures the flexibility value which may be produced during the implementation of the project. Results: The results indicate that those who use the real option method show lower EC to a failed project than those who merely use the net present value method. Conclusion/Recommendations: The major conclusion might be that using the real option method in capital budgeting can affect the users’ behavior and decisions and lead to better decision-making in the long-term projects. In view of the fact that long-term investment projects are costly and time-consuming, a greater need is felt for better methods of evaluating such projects and, in consequence, researchers should also consider the other affective aspects of using real method options on the users' behavior and decisions.