Incorporating Managerial Information into Real Option Valuation
The adoption of real options analysis (ROA) by practitioners, despite being widely viewed as a superior method for valuing managerial flexibility, remains limited due to varied difficulties in its implementation. In this work, we propose an approach that utilizes cash-flow estimates from managers as key inputs and results in project value cash-flows that exactly match the arbitrarily distributed estimates. We achieve this through the introduction of an observable, but not tradable, market stochastic driver process which drives the project’s cash-flow, rather than modeling the project value directly. Our framework can be used to value managerial flexibilities and obtain hedges in an easy to implement manner for a variety of real options such as entry/exit, multistage, abandonment, etc. As well, our approach to ROA provides a co-dependence between cash-flows, is consistent with financial theory, requires minimal subjective input of model parameters, and bridges the gap between theoretical ROA frameworks and practice.
KeywordsReal Option Optimal Investment Geometric Brownian Motion Idiosyncratic Risk Employee Stock Option
SJ would like to thank NSERC for partially funding this research.
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