Rules of Thumb in Real Options Analysis

Abstract

In this normative paper, we derive payback period (PBP) and internal rate of return (IRR) in the presence of real options. In a Kulatilaka - Trigeorgis General Real Option Pricing Model, we derive the expected value of these two decision rules that corresponds to the expected NPV Bellman dynamic programming maximizing strategy in the presence of the options to wait, to mothball and to abandon. A number of original results are derived for an all equity financed firm. Expected PBP and IRR at time 0 are derived together with their distribution. These new methods are applied to a case study in shipping finance. Real options are shown to be value enhancing and shortfall decreasing also with respect to thumb rules: expected IRR is increased while expected PBP is decreased. Probabilities of earning negative returns are reduced together with those of not recovering initially invested capital.

Our model gives a more intuitive insight into the dynamic optimal behavior which is endogenous to real options valuation models showing plainly how the representative agent would probably manage optimally her project. This would help to compare optimally dynamic behavior with current practice and to conclude whether real options are a simple pure academic abstraction or a realistic model.

Keywords: Real Options, Internal Rate of Return, IRR, Payback Period, PBP, Net Present Value, NPV

JEL Classification: G13, G31