MULTI-STAGE CAPITAL INVESTMENT OPPORTUNITIES AS COMPOUND REAL Options

Abstract Real options provide a new and productive way to view corporate investment decisions as options. Multi-stage or sequential-investment decisions are an important class of real options with embedded managerial flexibility. These multi-stage real options involve a bundle of interrelated investment opportunities, with the early upstream opportunities creating potentially valuable discretionary downstream opportunities. We investigate a multi-stage project setting where each investment opportunity derives revenues from different markets but share common technological resources. In such a setting, one should consider the underlying asset volatility of each investment opportunity in a compound-options framework. In this paper, we extend the binomial lattice framework to model a multi-stage investment as a compound real option when several uncorrected underlying variables exist. Volatility estimation is important for implementing real option models. Therefore, we develop the theoretical framework for estimating the volatility parameter of an underlying variable using Monte Carlo simulation technique.

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