Applying Real Option Analysis with NPV-Embedded Binomial Trees

Tom Arnold

Chapter Chapter 5 in A Pragmatic Guide to Real Options, 2014, pp 85-115 from Palgrave Macmillan

Abstract: 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.

Keywords: Cash Flow; Real Option; Future Cash Flow; Binomial Tree; Cash Inflow (search for similar items in EconPapers)
Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:pal:palchp:978-1-137-39116-2_5

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DOI: 10.1057/9781137391162_5

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