Valuing Real Options with Estimation Error: DCF Versus No-Arbitrage

30 Pages Posted: 13 Sep 2012

Date Written: September 12, 2012

Abstract

This paper investigates the effect of uncertainty about input parameters on the accuracy of real option valuation. It compares the error from no-arbitrage valuation with the error from using DCF. Despite the theoretical superiority of no-arbitrage valuation it is shown to be less accurate than DCF in many cases. In the common situation where no-arbitrage valuation first requires the value of the underlying asset to be estimated by DCF it is likely that direct DCF valuation of the real option is more accurate. The paper offers a possible explanation for the resistance of practitioners to using no-arbitrage methods to value real options, and the continued dominance in practice of apparently cruder methods.

Keywords: real options, valuation, DCF, no-arbitrage

JEL Classification: G12, G13, G31

Suggested Citation

Cooper, Ian Anthony, Valuing Real Options with Estimation Error: DCF Versus No-Arbitrage (September 12, 2012). Available at SSRN: https://ssrn.com/abstract=2145211 or http://dx.doi.org/10.2139/ssrn.2145211

Ian Anthony Cooper (Contact Author)

London Business School ( email )

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