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Conventional financial tools can lead to supply chain mistakes. Most managers use the discounted cash flow (DCF) model to help them make decisions such as where to locate a new manufacturing plant or whether to use a foreign or domestic supplier. But DCF typically undervalues flexibility-and as a result, companies may end up with supply chains that are low cost as long as everything proceeds according to plan but extremely expensive if problems arise. De Treville, of the University of Lausanne, and Trigeorgis, of the University of Cyprus, argue that you can avoid this pitfall by complementing a DCF analysis with a real options valuation. This technique lets you put a dollar figure on flexibility in the supply chain and helps you assess the value of having direct control. The authors explain how a real options approach helped the Swiss company Flexcell decide whether to locate a new plant at home or abroad. The CEO was able to show his board that the flexibility afforded by a factory near company headquarters would more than make up for the 15% per unit cost savings that would have been realized at a factory elsewhere. He also demonstrated that the costs resulting from a disruption to a Swiss plant would be much lower than those resulting from a disruption to a foreign plant. The decision to manufacture at home has paid off handsomely, especially in view of the uncertainties created by the current economic crisis.

All companies making big-budget investment decisions face the same basic dilemma: On the one hand, they must make timely, strategic investments to prevent rivals from gaining ground. On the other, they must avoid tying up too much cash in risky projects, especially during times of market uncertainty. The traditional valuation methods - namely, discounted cash flow and real options - fall short in resolving this dilemma. Neither one, on its own, properly incorporates the impact of demand and price volatility in an industry while also taking into account additional investments that the firm and its competitors may make. In this article, Nelson Ferreira, an associate principal at McKinsey & Company in Sao Paulo; Jayanti Kar, an associate at McKinsey & Company in Toronto; and Lenos Trigeorgis, a professor of finance at the University of Cyprus and the president of the Real Options Group, present a valuation tool that overcomes the shortfalls of those analytic approaches. The tool, called option games, combines real options (which predict the evolution of prices and demand) and game theory (which captures competitors' moves) to quantify the value of both flexibility and commitment, allowing managers to make rational choices between alternative investment strategies. Option games will be of particular value to companies facing high-stakes decisions, such as those involving millions of dollars in capital investment, in a volatile environment in which their moves and those of their competitors clearly affect each other.

To understand the recent trend toward privatization of infrastructure assets (e.g., airports), this article proposes a valuation methodology based on real options and game theory analysis that enables assessing when investors might overpay for infrastructure assets over standard discounted cash flow methods and when a premium is justified for their operating flexibility or strategic growth option value. While some infrastructure asset acquisitions may involve financial transactions whose value derives primarily from their expected cash flows, many of these infrastructure investments provide a platform and create the strategic context within which the firm can grow.