An Opportunity Cost Model to Value a Deferral Option

Abstract

This paper discusses the real option valuation approach based on the familiar opportunity cost concept. The model presented decomposes the deferral option value into four contributing components - interest earning opportunity, expected opportunity gain, present value, and investment cost. After demonstrating the equivalence of the opportunity model to Cox, Ross, and Rubinstein’s (CRR) binomial lattice approach, its attributes are discussed through simple numerical examples. In contrast with the CRR approach, the opportunity model’s transparency provides an intuitive and economical baseline for managerial discussion and decision-making. Additionally, the appropriateness of risk-neutral probabilities to value real options is discussed in the context of actual (or real) probabilities. Finally, it should be emphasized that the discussion of the paper be concentrated on the opportunity costs inherently embedded in the real options value, therefore, it is different from other works per se which consider them as the exogenous input to the real options value

Keywords: binomial lattice model, capital budgeting, decision making/process, opportunity cost, real options

JEL Classification: G12,G31