Using the Wacc to Value Real Options
13 Pages Posted: 8 May 2004
Date Written: May 7, 2004
We present a real option valuation using the weighted average cost of capital (WACC). This is an alternative to risk-neutral real option valuation. Using the WACC involves a marginal increase in mathematical complexity, but it is easy to implement in a spreadsheet, and it is easy to present to management. Our analysis reveals, however, that because the real option valuation is immune to choices of admissible discount rates (as per Arnold and Crack 2003a), the critical issue is correct estimation of volatility, not choice of discount rate. We also point out that the natural and conservative tendency to overestimate risk is anything but conservative in a real option valuation.
Keywords: Real Options, Risk-Neutral Valuation, WACC, Binomial Option Pricing, Volatility Estimation
JEL Classification: G12, G13, G31
Suggested Citation: Suggested Citation