Real Option Valuation: Application and Illustration
Topic 46 presents an example of the mechanics of doing real option valuation. The discounted cash flow example is contrasted with the real option approach to value a timing call option.
The reader is encouraged to take the time to read the text in conjunction with the referenced Appendices to gain the appropriate level of understanding of the subject matter discussed in the narrative. Appendices are either presented at the end of this and each remaining Topic or are available for review and download on this book's companion Web site (see the About the Web Site page for login information).
- Any investment opportunity has a range of potential results and volatility:
- The investment can overrun or underrun cost estimates.
- The returns have the potential to be very good or very bad.
- The returns can occur sooner or later than expected.
- The volatility range and time to exercise are what make option valuation a risk management tool and yields the flexibility advantage of waiting before investing. Waiting has value. Real option valuation determines the value of the right to wait before investing, hence the value of the option.
REAL OPTION VALUATION: AN EXAMPLE
- For purposes of illustrating how a real option value is determined, consider the simple timing call option scenario in Appendix 46.1 valued which contrasts:
- The net present value approach
- A simplified illustration presenting the elements of the real option ...