Risk-adjusted Valuation of the Real Option to Invest

Carol Alexander and Xi Chen
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Xi Chen: ICMA Centre, Henley Business School, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: This paper resolves the conceptual ambiguity of real option value and derives a model using risk-adjusted discount rates that can be applied to value the option to invest in a project. The approach adopts stochastic revenue and costs which provide a general solution with the added virtue of applicability. We found the option value arises from the difference between an indi- vidual investor and the market in financing efficiency and risk preferences. Investors taking on idiosyncratic risks are crucial to obtaining the real option value; hedging project risks can significantly reduce the associated real option value.

Keywords: real option; decision making; investment opportunity; geometric Brownian motion; option to invest; discounted cash flow; change of measure; risk tolerance; risk aversion; idiosyncratic risk; gold mine (search for similar items in EconPapers)
JEL-codes: C44 D81 G11 G30 (search for similar items in EconPapers)
Date: 2014-12
New Economics Papers: this item is included in nep-cfn, nep-ore and nep-ppm
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Persistent link: https://EconPapers.repec.org/RePEc:rdg:icmadp:icma-dp2014-19

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