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A Pragmatic Guide to Real OptionsApplying Real Option Analysis with NPV-Embedded Binomial Trees

A Pragmatic Guide to Real Options: Applying Real Option Analysis with NPV-Embedded Binomial Trees [In the first two chapters, net present value (NPV) analysis was demonstrated to be a very limited way to analyze the viability of a project, and it was shown that making decisions more sequential rather than a full commitment of capital at the start of a project creates value due to the ability to limit losses (or possibly by expanding the project when the opportunity presents itself). In the previous two chapters, binomial tree techniques were introduced to provide a probability distribution of the future value of an underlying asset (generally a stock) in order to price options or an option-like contract. The binomial tree can be used with a risk-adjusted discount rate (risk-adjusted pricing) or with the risk-free rate (risk-neutral pricing) to generate an option’s value. Risk-neutral pricing is easier to execute, but risk-adjusted pricing may be more “agreeable” to a decision-maker who is suspicious of using a risk-free rate to discount cash flows for a project that is risky.] http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png

A Pragmatic Guide to Real OptionsApplying Real Option Analysis with NPV-Embedded Binomial Trees

Arnold, Tom
Springer Journals — Nov 12, 2015
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30 pages

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Publisher
Palgrave Macmillan US
Copyright
© Palgrave Macmillan, a division of Nature America Inc. 2014
ISBN
978-1-349-48301-3
Pages
85 –115
DOI
10.1057/9781137391162_5
Publisher site
See Chapter on Publisher Site

Abstract

[In the first two chapters, net present value (NPV) analysis was demonstrated to be a very limited way to analyze the viability of a project, and it was shown that making decisions more sequential rather than a full commitment of capital at the start of a project creates value due to the ability to limit losses (or possibly by expanding the project when the opportunity presents itself). In the previous two chapters, binomial tree techniques were introduced to provide a probability distribution of the future value of an underlying asset (generally a stock) in order to price options or an option-like contract. The binomial tree can be used with a risk-adjusted discount rate (risk-adjusted pricing) or with the risk-free rate (risk-neutral pricing) to generate an option’s value. Risk-neutral pricing is easier to execute, but risk-adjusted pricing may be more “agreeable” to a decision-maker who is suspicious of using a risk-free rate to discount cash flows for a project that is risky.]

Published: Nov 12, 2015

Keywords: Cash Flow; Real Option; Future Cash Flow; Binomial Tree; Cash Inflow

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