Real Option Valuation using NPV

16 Pages Posted: 7 Jan 2005  

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance

Date Written: November 19, 2004

Abstract

We show that a careful net present value (NPV) using risk-adjusted discount rates produces a real option valuation identical to that obtained from a risk-neutral option valuation. This general result demonstrates that NPV and risk-neutral option valuation are equivalent. Although equivalent, we argue that in this context the implementation of a traditional risk-adjusted NPV will often be computationally infeasible - for reasons related to sheer volume of disaggregated sample paths. Fortunately, the risk-adjusted option valuation framework of Arnold and Crack (2000) allows this same risk-adjusted NPV to be executed by seamlessly discounting the payoffs to different sample paths using the correct risk-adjusted discount rates. It also allows the analyst to capture physical probability information not available in a risk-neutral valuation.

Keywords: Real option valuation, NPV, risk-adjusted option valuation, risk-neutral option valuation

JEL Classification: G12, G13, G31

Suggested Citation

Arnold, Tom and Crack, Timothy Falcon, Real Option Valuation using NPV (November 19, 2004). Available at SSRN: https://ssrn.com/abstract=644081 or http://dx.doi.org/10.2139/ssrn.644081

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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