Annals of Operations Research

, Volume 259, Issue 1–2, pp 173–190 | Cite as

Using managerial revenue and cost estimates to value early stage real option investments

  • Sebastian Jaimungal
  • Yuri LawryshynEmail author
Original - OR Modeling/Case Study


Real options analysis is widely recognized as a superior method for valuing projects with managerial flexibilities. Yet, its adoption remains limited due to varied difficulties in its implementation. In this work, a real options approach that utilizes managerial cash-flow estimates to value early stage project investments is proposed. Our model is based on the assumption that managers can provide pessimistic, likely and optimistic sales and gross margin percent estimates. A market sector indicator is introduced, which is assumed to be correlated to a tradeable market index, which drives the project’s sales estimates. Another indicator, assumed partially correlated to the sales indicator drives the gross margin percent estimates. In this way a cash-flow process can be modelled that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash-flow in a financially consistent manner. The method requires minimal subjective input of model parameters and is very easy to implement, based on simple managerial estimates.


Investment analysis Real options Risk-neutral valuation Cash-flow analysis Project valuation 


  1. Amram, M., & Kulatilaka, N. (1999). Real options: Managing strategic investment in an uncertain world. Massachusetts: Harvard Business School Press.Google Scholar
  2. Barton, K., & Lawryshyn, Y. A. (2011). Integrating real options with managerial cash flow estimates. Engineering Economist, 56(3), 254–273.CrossRefGoogle Scholar
  3. Bennouna, K., Meredith, G., & Marchant, T. (2010). Improved capital budgeting decision making: Evidence from canada. Management Decision, 48(2), 225–247.CrossRefGoogle Scholar
  4. Berk, J., Green, R., & Naik, V. (2004). Valuation and return dynamics of new ventures. The Review of Financial Studies, 17(1), 1–35.CrossRefGoogle Scholar
  5. Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81, 637–659.CrossRefGoogle Scholar
  6. Block, S. (2007). Are real options actually used in the real world? Engineering Economist, 52(3), 255–267.CrossRefGoogle Scholar
  7. Borison, A. (2005). Real options analysis: Where are the emperor’s clothes? Journal of Applied Corporate Finance, 17(2), 17–31.CrossRefGoogle Scholar
  8. Brandao, L., & Dyer, J. (2005). Decision analysis and real options: A discrete time approach to real option valuation. Annals of Operations Research, 135, 21–39.CrossRefGoogle Scholar
  9. Brennan, M. J., & Schwartz, S. (1985). Evaluating natural resource investments. Journal of Business, 58(2), 135–157.CrossRefGoogle Scholar
  10. Cerny, A. (1999). Minimal martingale measure, capm, and representative agent pricing in incomplete markets. Technical report, Cass Business School. Available at SSRN:
  11. Chen, T., Zhang, J., & Lai, K.-K. (2009). An integrated real options evaluating model for information technology projects under multiple risks. International Journal of Project Management, 27, 776–786.CrossRefGoogle Scholar
  12. Collan, M., Fullér, R., & Mezei, J. (2009). A fuzzy pay-off method for real option valuation. Journal of Applied Mathematics and Decision Sciences, 2009, 1–14.CrossRefGoogle Scholar
  13. Copeland, T., & Antikarov, V. (2001). Real options: A practitioner’s guide. New York: Norton and Company: W. W.Google Scholar
  14. Copeland, T., & Tufano, P. (2004). A real-world way to manage real options. Harvard Business Review, 82(3), 90–99.Google Scholar
  15. Datar, V., & Mathews, S. (2004). European real options: An intuitive algorithm for the black- scholes formula. Journal of Applied Finance, 14(1), 45–51.Google Scholar
  16. Dixit, A., & Pindyck, R. (1994). Investment under uncertainty. Princeton: Princeton University Press.Google Scholar
  17. Föllmer, H., & Schweizer, M. (1991). Applied Stochastic Analysis : Stochastics Monographs, Chapter Hedging of contingent claims under incomplete information, pp. 389–414. Gordon and Breach, London.Google Scholar
  18. Hartmann, M., & Hassan, A. (2006). Application of real options analysis for pharmaceutical R&D project valuationempirical results from a survey. Research Policy, 35, 343–354.CrossRefGoogle Scholar
  19. Jaimungal, S., & Lawryshyn, Y. (2015). Incorporating managerial information into real option valuation. In L. M. Ad, R. and R. Sircar (Eds.), Commodities,Energy and Environmental Finance, Vol. 74 of Fields Institute Communications, pp. 213–238. Springer-Verlag New York.Google Scholar
  20. Luehrman, T. (1997). What’s it worth? a general manager’s guide to valuation. Cambridge: Harvard Business Review.Google Scholar
  21. Luehrman, T. (1998a). Investment opportunities as real options: Getting started on the numbers. Cambridge: Harvard Business Review.Google Scholar
  22. Leuhrman, T. (1998b). Strategy as a portfolio of real options. Cambridge: Harvard Business Review.Google Scholar
  23. Luo, L.-M., Sheu, H.-J., & Hu, Y.-P. (2008). Evaluating R&D projects with hedging behavior. Research Technology Management, 51(6), 51–57.Google Scholar
  24. Mathews, S. (2009). Valuing risky projects with real options. Research Technology Management, 52(5), 32–41.Google Scholar
  25. Mathews, S., & Datar, V. (2007). A practical method for valuing real options: The boeing approach. Journal of Applied Corporate Finance, 19(1), 95–104.CrossRefGoogle Scholar
  26. Myers, S. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5, 147–175.CrossRefGoogle Scholar
  27. Oriani, R., & Sobrero, M. (2008). Uncertainty and the market valuation of R&D within a real options logic. Strategic Management Journal, 29(4), 343–361.CrossRefGoogle Scholar
  28. Pendharkar, P. (2010). Valuing interdependent multi-stage it investments: A real options approach. European Journal of Operational Research, 201(3), 847–859.CrossRefGoogle Scholar
  29. Shockley, R. (2006). An applied course in real options valuation. Nashville: South-Western College Pub.Google Scholar
  30. Smith, J., & Nau, R. (1995). Valuing risky projects: Option pricing theory and decision analysis. Management Science, 41(5), 795–816.CrossRefGoogle Scholar
  31. Trigeorgis, L. (1996). Real options: Managerial flexibility and strategy in resource allocation. Cambridge: The MIT Press.Google Scholar
  32. Truong, G., Partington, G., & Peat, M. (2008). Cost-of-capital estimation and capital-budgeting practice in australia. Australian Journal of Management, 33(1), 95–122.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media New York 2016

Authors and Affiliations

  1. 1.Department of StatisticsUniversity of TorontoTorontoCanada
  2. 2.Department of Chemical Engineering and Applied Chemistry, Centre for Management of Technology and Entrepreneurship (CMTE)University of TorontoTorontoCanada

Personalised recommendations