they have negative present values. As a result, investment opportunities in those areas are systematically undervalued, with detrimental consequences for future competitiveness.
To overcome this capital budgeting shortcoming, finance theory has recently provided some very powerful extensions to the traditional methodology. Those extensions are based on what is known as option pricing theory (OPT), or contingent claim analysis. The seminal contributions to OPT were made at MIT in the late 1960s and early 1970s. OPT had a direct and significant impact in practice through its applications in financial markets (pricing of traded "call" and "put" options). Following that success, the possibility of extending OPT to real capital investment decisions was soon realized. As a result, a significant volume of research has been carried out on this topic. By now, it has been well established that option-like characteristics permeate virtually every aspect of the complex investment decisions facing an industrial firm. It is also perceived today that OPT provides the best and most economically consistent set of quantitative tools for capturing complex interactions of time and uncertainty inherent in investment decisions.
Significant industrial applications of OPT cover a very broad range of subjects. They include the evaluation of research and development projects, natural resource exploration, flexible production facilities, and optimal timing and abandonment decisions, to cite just a few. The analytical techniques involved in OPT require the use of stochastic calculus and general equilibrium pricing methods of financial economics. A continuous lognormal diffusion process, sometimes superimposed on a Poisson or jump process, is commonly used to model uncertainty.
At General Motors (GM), OPT has been successfully applied to capital investment decisions involving new manufacturing technologies, new product introduction, and flexible plant capacity. More specifically, it has been used as a financial tool to evaluate developmental activities for new technologies that would require sequential capital investments. Investment at each stage was modeled as buying an option to invest in the next stage. Implementing this approach explicitly takes into account the value of the upside potential of a new product or technology. In addition, OPT was instrumental in generating significant insights about investment in flexible plant capacity. It helped