Real Options in Ship and Force Structure Analysis: A Research Agenda

In the evaluation of large, risky expenditures on long-lived capital investments, conventional engineering economic analysis methods do not provide adequate insight into the option value of managerial flexibility and strategic interactions. A common practical remedy is to set aside the (incomplete) analysis in favor of intuition and judgment, which in many instances results from tacit knowledge of embedded option-type value. If this value could be explicitly documented then the decision criteria would be more transparent. With this in mind, a "real" options analogy with financial options has been proposed; the attraction is that methods for valuing financial options are mature. Naval ship design and acquisition is an option-laden environment. Therefore if a naval version of the real options analogy were developed, it would add considerable insight. In this paper, the motivation for option-based analysis is introduced, the basic mechanics of financial options are reviewed, and an agenda for developing options-informed naval analyses is suggested.