Incorporating Managerial Information into Real Option Valuation

Fields Volume on Commodities, Energy, and Environmental Finance, Forthcoming

25 Pages Posted: 24 Dec 2010 Last revised: 27 Apr 2015

Sebastian Jaimungal

University of Toronto - Department of Statistics

Yuri Lawryshyn

University of Toronto

Date Written: January 3, 2011

Abstract

The adoption of real options analysis (ROA) by practitioners, despite being widely viewed as a superior method for valuing managerial flexibility, remains limited due to varied difficulties in its implementation. In this work, we propose an approach that utilizes cash-flow estimates from managers as key inputs and results in project value cash-flows that exactly match the arbitrarily distributed estimates. We achieve this through the introduction of an observable, but not tradable, market stochastic driver process which drives the project's cash-flow, rather than modeling the project value directly. Our framework can be used to value managerial flexibilities and obtain hedges in an easy to implement manner for a variety of real options such as entry/exit, multistage, abandonment, etc. As well, our approach to ROA provides a co-dependence between cash-flows, is consistent with financial theory, requires minimal subjective input of model parameters, and bridges the gap between theoretical ROA frameworks and practice.

Keywords: Real Options, Managerial Information, Cash-Flow Replication, Indifference Pricing, Entry-Exit Problem

JEL Classification: G12, G13, G31, C60

Suggested Citation

Jaimungal, Sebastian and Lawryshyn, Yuri, Incorporating Managerial Information into Real Option Valuation (January 3, 2011). Fields Volume on Commodities, Energy, and Environmental Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1730355 or http://dx.doi.org/10.2139/ssrn.1730355

Sebastian Jaimungal (Contact Author)

University of Toronto - Department of Statistics ( email )

100 St. George St.
Toronto, Ontario M5S 3G3
Canada

HOME PAGE: http://www.utstat.utoronto.ca/sjaimung

Yuri Lawryshyn

University of Toronto ( email )

Department of Statistical Sciences
Toronto, Ontario M5S 3G8
Canada

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