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Using the WACC to Value Real Options

13 Pages Posted: 8 May 2004  

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: May 7, 2004

Abstract

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

Arnold, Tom and Crack, Timothy Falcon, Using the WACC to Value Real Options (May 7, 2004). Available at SSRN: https://ssrn.com/abstract=541662 or http://dx.doi.org/10.2139/ssrn.541662

Thomas M. Arnold

University of Richmond - E. Claiborne Robins School of Business ( email )

1 Gateway Drive
Richmond, VA 23173
United States
804-287-6399 (Phone)
804-289-8878 (Fax)

Timothy Falcon Crack (Contact Author)

University of Otago - Department of Accountancy and Finance ( email )

Dunedin
New Zealand

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