Valuing Real Options: Frequently Made Errors

15 Pages Posted: 20 Jul 2001 Last revised: 26 May 2019

See all articles by Pablo Fernandez

Pablo Fernandez

University of Navarra - IESE Business School

Date Written: May 24, 2019

Abstract

La versión española de este artículo se puede encontrar en: http://ssrn.com/abstract=1159045.

In this paper, we analyze frequently made errors when valuing real options. The best way of doing it is through examples. We start by analyzing Damodaran proposal to value the option to expand the business of Home Depot. Some of the errors and problems of this and other approaches are:

- Assuming that the option is replicable and using Black and Scholes' formula.

- The estimation of the option's volatility is arbitrary and has a decisive effect on the option's value.

- As there is no riskless arbitrage, the value of the option to expand basically depends on expectations about future cash flows. However, Damodaran assumes that this parameter does not influence the option's value (he does not use it) because he assumes that the option is replicable.

- It is not appropriate to discount the expected value of the cash flows at the risk-free rate (as is done implicitly when Black and Scholes' formula is used) because the uncertainty of costs and sales in the exercise date may be greater or less than that estimated today.

- Damodaran's valuation assumes that we know exactly the exercise price.

- Belief that options' value increases when interest rates increase.

- "Play" with volatility.

- Valuing contracts as real options when they are not.

Keywords: real options, volatility, Black and Scholes, option replication

JEL Classification: G12, G31, M21

Suggested Citation

Fernandez, Pablo, Valuing Real Options: Frequently Made Errors (May 24, 2019). Available at SSRN: https://ssrn.com/abstract=274855 or http://dx.doi.org/10.2139/ssrn.274855

Pablo Fernandez (Contact Author)

University of Navarra - IESE Business School ( email )

Camino del Cerro del Aguila 3
28023 Madrid
Spain
+34 91 357 0809 (Phone)
+34 91 357 2913 (Fax)

HOME PAGE: http://web.iese.edu/PabloFernandez/

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