Title: A practical analytical model for valuing early stage investments using real options

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.

DOI: 10.1504/IJOR.2016.075293

International Journal of Operational Research, 2016 Vol.25 No.4, pp.475 - 486

Published online: 10 Mar 2016 *

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