Real Option Valuation Using NPV

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