Evaluation of Real Options with Information Costs

Abstract

This paper presents a simple framework for the analysis, valuation and simulation of several real options in the presence of shadow costs of incomplete information. Information costs can be viewed as sunk costs in the spirit of Merton’s (1987) model of capital market equilibrium with incomplete information. We incorporate these sunk costs in standard discounted cash flow techniques and present the basic concepts of real options. The justification of information costs in real projects is based on the observation that R&D needs to be done before investment decisions. These costs account for all the expenses needed to be informed about an investment opportunity and the management of projects. This analysis extends the models in Bellalah (1999, 2001) for the valuation of real options within information uncertainty. We present valuation procedures and simulations for the values of common real options in the presence of shadow costs of incomplete information.

Keywords: Real Option, Asset Pricing, Option Pricing, Market Efficiency, Capital Budgeting, Investment Policy, Information Costs

JEL Classification: G12, G13, G14, G31