Sensitivity Analysis for Cash Flow Simulation Based Real Option Valuation

20 Pages Posted: 19 Sep 2011  

Tero J. Haahtela

Aalto University

Date Written: February 16, 2011

Abstract

Sensitivity analysis identifies the critical aspects of the investment model that affect model output uncertainty. Common sensitivity analysis on options considers how the solution changes as a result of change in one of the key parameters (underlying asset value, volatility, exercise price, interest rate, time to maturity, dividends). In case of cash flow simulation based real options, these are mostly indirect variables that are computed based on the primary input variables – demand, unit selling price, and unit costs – in the cash flow calculation. The method presented in this paper combines the uncertainties in the underlying asset together by simulation, and then uses regression analysis approach for estimating how a change in a primary variable or variables affects simultaneously the stochastic process parameters of expected value and volatility during different time periods. As a result, the presented method shows how a change in a primary variable affects project value with real options. This information is also essential as it shows decision makers which uncertainties to follow, and thus this mitigates the common black box syndrome of consolidated cash flow simulation based methods.

Keywords: real options, sensitivity analysis, cash flow simulation, volatility

JEL Classification: G31, G13

Suggested Citation

Haahtela, Tero J., Sensitivity Analysis for Cash Flow Simulation Based Real Option Valuation (February 16, 2011). Available at SSRN: https://ssrn.com/abstract=1864909 or http://dx.doi.org/10.2139/ssrn.1864909

Tero J. Haahtela (Contact Author)

Aalto University ( email )

02015 Espoo
Finland

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