Incorporating Managerial Information into Real Option Valuation

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