Real Option Analysis Project Valuation

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Recommended: Critical evaluation of project

Theoretical background: Project valuation
There are only two elements to determine an investment valuation using NPV approach: the difference between present value of the investment’s cash flows and the investment cost that are discounted by the risk-free rate or time value of money. The project should commence if it has a positive NPV, otherwise it should be abandoned.
The net present value (NPV) approach assumes the investment opportunity is a now-or-never decision, and once the investment is undertaken, there is no scope for managers to react to new information and to change course. It may undervalue the project by suppressing the value of flexibility embedded within many options.
Real options analysis as a tool for making investment decision is taking into account uncertainty and building flexibility in the system. In the real option analysis, more elements are drawn as follows: 1) the time elapsed until the option is no longer valid or time to expiration, 2) the volatility of the returns to the investment or underlying risky asset. It offers a supplement to the NPV method that considers managerial flexibility in making decisions regarding the real assets of the firm.
A real option analysis always starts from the standard NPV analysis. In fact, the standard discounted cash flow (DCF) approach is a special case of the real option analysis, evaluating the project as if no flexibility is present. It is therefore vital to start real option analysis to correct standard NPV valuation. The total value of a project is expressed by the following formula. (Luehrman, 1998)
Project value=NPV+Flexibility
DCF and NPV
The main approach in traditional financial method to value a project is the discounted cash flow (DCF) model. This model is...

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...wnian motion is described by: dS_t=μS_t dt+σS_t dW_t
Where W_t is a Wiener process or Brownian motion, μ (the percentage drift) and σ (the percentage volatility) are constants.
The price of a call option in a risk-neutral world is obtained as:
Value of call options=[N(d_1 )×P]-[N(d_2 )×PV (EX)]
Where
d_1=(log⁡ (P/PV(EX) ))/(σ√t)+(σ√t)/2 d_2=d_1-σ√t N(d)=Cumulative normal probability density function
EX=Exercise price of option,
PV(EX) is calculated by discounting at the risk-free interest rate r_f t= Number of periods to exercise date
P=Price of the stock now σ=Standard deviation per period of (continuously compounded) rate of return
The principal assumption behind Black-Scholes model is that returns are of lognormal distribution; besides, there are a number of other assumptions which may lead to wrong results for critical cases. (Kodukula & Papudesu, 2006)

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