A practical analytical model for valuing early stage investments using real options
by Yuri Lawryshyn
International Journal of Operational Research (IJOR), Vol. 25, No. 4, 2016

Abstract: In this work, we build on a previous real options approach that utilises managerial cash-flow estimates to value early stage project investments. Through a simplifying assumption, where we assume that the managerial cash-flow estimates are normally distributed, we derive a closed-form solution to the real option problem. The model is developed through the introduction of a market sector indicator, which is assumed to be correlated to a tradeable market index and drives the project's cash-flow estimates. In this way we can model a cash-flow process that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash-flow in a financially consistent manner under the risk-neutral minimum martingale measure. The method requires minimal subjective input of model parameters and is very easy to implement.

Online publication date: Thu, 10-Mar-2016

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