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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
  • 271 Downloads

Abstract

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.

Keywords

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

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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

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