Embedding an NPV Analysis into a Binomial Tree with a Real Options Application

Abstract

Financial statements and an accompanying NPV calculation are embedded into a binomial tree. This generalization of traditional static NPV analysis allows the financial statements to both evolve through time and, at any given time, to vary with states of the world (similar to a Monte Carlo analysis). Modelling the component cash flows in a tree reveals dynamic detailed structure, leading to a more useful NPV analysis than if only the final cash flow value was modelled in a tree or if component cash flows were modelled without a tree. This dynamic detail provides credible cash flow forecasts that can improve hedging of adverse events and allow for leveraging of beneficial circumstances. The financial statements take the form of pro forma after-tax operating cash flows in this treatment. However, any cash flow model driven by the random variable in the tree and allowing for separate treatment of fixed costs, can be used. The benefits of this technique are illustrated via a real options example.

Keywords: Real option, Binomial tree, embedded NPV analysis

JEL Classification: G30, G31, G32, G13