Real Option Valuation using NPV
University of Richmond - E. Claiborne Robins School of Business
Timothy Falcon Crack
University of Otago - Department of Finance and Quantitative Analysis
November 19, 2004
We show that a careful net present value (NPV) using risk-adjusted discount rates produces a real option valuation identical to that obtained from a risk-neutral option valuation. This general result demonstrates that NPV and risk-neutral option valuation are equivalent. Although equivalent, we argue that in this context the implementation of a traditional risk-adjusted NPV will often be computationally infeasible - for reasons related to sheer volume of disaggregated sample paths. Fortunately, the risk-adjusted option valuation framework of Arnold and Crack (2000) allows this same risk-adjusted NPV to be executed by seamlessly discounting the payoffs to different sample paths using the correct risk-adjusted discount rates. It also allows the analyst to capture physical probability information not available in a risk-neutral valuation.
Number of Pages in PDF File: 16
Keywords: Real option valuation, NPV, risk-adjusted option valuation, risk-neutral option valuation
JEL Classification: G12, G13, G31
Date posted: January 7, 2005
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