Authors: Yuri Lawryshyn
Addresses: Centre for the Management of Technology and Entrepreneurship, University of Toronto, Toronto, ON, Canada
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.
Keywords: real options; managerial estimates; closed-form solution; project valuation; cash-flow replication; analytical modelling; early stage investments; project investments.
International Journal of Operational Research, 2016 Vol.25 No.4, pp.475 - 486
Published online: 10 Mar 2016 *Full-text access for editors Access for subscribers Purchase this article Comment on this article