From Expected Cash Flows to Real Options
27 Pages Posted: 26 Jun 2015
Date Written: June 25, 2015
This article attempts to answer some of the most common questions about how to apply the theory of real options to practice. Its primary focus is on how to start with irregular expected cash flows of the underlying risky asset that do not follow any regular stochastic process and end up with a legitimate real options analysis. It is organized as follows. Section I is a simple numerical example. Section II discusses the necessary theory -- three key assumptions. Section III discusses how to estimate volatility. Section IV goes on to describe six short case examples where the solution process worked well. The paper discusses why traditional NPV methodology forces false mutually exclusive alternatives and how real options solves the problem, and illustrates how modularity of project construction can be more valuable than significant economies of scale.
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