Investment Decision-making Using Optional Models

Introduction ix

Chapter 1. Risk and Flexibility Integration in Valuation 1

1.1. Introduction 1

1.2. The scope of real options 2

1.2.1. The concept of real options 3

1.2.2. Empirical use of real options 7

1.2.3. Paradigms in options 12

1.3. Valuation of investments by real options 20

1.3.1. Optional valuation of investments in a discrete-time approach 20

1.3.2. Optional valuation of investments in a continuous-time approach 28

1.4. Option model extensions by incorporating new parameters (Levyne and Sahut 2008) 35

1.4.1. Stochastic volatility 36

1.4.2. Transaction costs and models with jumps 39

1.4.3. Option pricing 41

1.5. Conclusion 44

Chapter 2. Optional Modeling of Investment Choices and Surplus Value Linked to the Option to Invest 47

2.1. Introduction 47

2.2. Framework of optional interactions and option to develop an investment project 48

2.2.1. Real investment opportunity 50

2.2.2. Opportunity to postpone decision-making to infinity 52

2.2.3. Development cycle and taking into account new information within dependent projects and focusing on research and development 62

2.3. Option to exchange and abandon an investment project 65

2.3.1. Real options within the replacement cycle and disinvestment alternatives 66

2.3.2. The value of an investment project in the natural resources sector 69

2.3.3. Valuation of the abandonment option by investors 85

2.4. Growth option resulting from investment decisions and acquisition strategies 88

2.4.1. Company profiles justifying growth option value 89

2.4.2. Growth option value related to interactions between financing and investment decisions 90

2.4.3. Acquisition strategies by the real options approach 98

2.5. Conclusion 106

Chapter 3. Data Generation Applied to Strategic and Operational Option Models 107

3.1. Introduction 107

3.2. Determining the right time to invest 107

3.2.1. Application to the carry option 108

3.2.2. Application of the Dixit and Pindyck model 110

3.3. Flexibility of asset exchange, abandonment and temporary shutdown of projects 113

3.3.1. Application to the exchange option 113

3.3.2. Application to the abandonment option 115

3.3.3. Application to the temporary shutdown option 116

3.4. Incorporation of development phases 121

3.4.1. Implementation of a two-stage investment project 121

3.4.2. Valuation of a sequential project 122

Conclusion 135

Appendices 139

Appendix 1. Demonstration of the CRR Formula 141

Appendix 2. Stochastic Differential Calculus 147

Appendix 3. Test of the Black and Scholes Formula and Return on the Log-Normal Distribution 155

Appendix 4. Demonstration of the Black and Scholes Formula 159

Bibliography 165

Index 173