Real Option and Consequences of a Sudden Cash Flows Decrease in Investment Strategies

Abstract:     
In this article we develop a real options approach to the consideration of a sudden drop in futures cash flows in an investment project and its impact on the investment strategy of the company. We apply our model in the context of investing in a wind energy project because of the relatively long life-span of such a project where cash flows show an exponential tendency due to increasing energy costs. However, this tendency could be altered as a result of a crisis. Therefore, it appears essential to include this risk factor in the evaluation of such a project.

The real options model developed also allows us to go beyond the traditional limits of the net present value by including in it: a random model of cash flows; the impact of a crisis and the possibility of delaying the project.

We show that the consequences of a jump are twofold since, on the one hand, it reduces the value of the project and, on the other hand, it delays the launching of the project. This time delay, however, reduces the negative impact of the drop in cash flows. This type of model thus allows one to handle the risk associated with the change of cash flows in long-term projects (sudden drop) better but is limited by taking into consideration a unique jump only.

Number of Pages in PDF File: 11

Keywords: real option, NPV, evaluation, crisis, jump, investment strategy

JEL Classification: G31, G13

Accepted Paper Series