Question

Why are the traditional tools of capital budget analysis called static?

What are the benefits of using the real options tool of analysis?

Answer 1

Traditional Tool of capital Budgeting analysis are called static because they don't take into consideration the Time value of money.Example of traditional tools are Payback Period, Accounting rate of return.Under Payback period we find out the years under which the original amount invested is return back but we don't take into consideration the time value of money that is we don't discount those inflow to zero period. In similar ways under Accounting rate of return we find %age of initial money invested is returned back.Here also we don't take into consideration time value of money.

The benefit of using real option tool of analysis is that they take into consideration the time value of money as well as opportunity cost. As the name suggest option, it gives the right and not the obligation to holder of option.Real option allow holder to either take capital budgeting decision now or at some fixed time in future.