Using the Wacc to Value Real Options

Posted: 30 Dec 2004

See all articles by Tom Arnold

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

Abstract

Use of the weighted-average cost of capital (WACC) in real-option valuation is an alternative to using risk-neutral real-option valuation. Using the WACC involves a marginal increase in mathematical complexity, but the method is easy to implement in a spreadsheet and easy to present to company managers, clients, and colleagues. Because real-option valuation is immune to choices of admissible discount rates, however, 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: Derivatives Instruments, Other, Corporate Finance, Capital Investment Decisions, Equity Investments, Fundamental Analysis and Valuation Models, Quantitative Tools, Mathmatical Methods

JEL Classification: G12, G13, G31

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon, Using the Wacc to Value Real Options. Financial Analysts Journal, Vol. 60, No. 6, pp. 78-82, November/December 2004. Available at SSRN: https://ssrn.com/abstract=636881

Thomas M. Arnold (Contact Author)

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

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

Dunedin
New Zealand

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