An Assessment of the Option to Reduce the Investment in a Project by the Binomial Pricing Model

Real options are a powerful complement to traditional methods of investment project assessment, such as the Net Present Value, when the value of some business strategies has to be included. This paper presents a methodology to calculate the value of the real option to reduce an investment project within one, two, and n periods. It is well known that the option to reduce quantifies the value of the operational flexibility available to protect a business against possible losses generated by the project. Thus, to derive its value, the procedure implemented here consists in obtaining a mathematical expression for each of the aforementioned periods, based on a detailed construction of every possible future scenario and its associated probability by the multiplicative binomial method. DOI: http://dx.doi.org/10.5755/j01.ee.28.5.17636

[1]  Hyoungbae Park,et al.  Real options analysis for renewable energy investment decisions in developing countries , 2017 .

[2]  Danny Cassimon,et al.  Compound Real Option Valuation with Phase-Specific Volatility: A Multi-Phase Mobile Payments Case Study , 2010 .

[3]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[4]  Paweł Merło.  Consequences of the Absence of Monotonicity of the NPV Function to the Assessment of the Effectiveness of Investment Projects , 2016 .

[5]  Discussion of “The Role of Volatility in Forecasting” , 2002 .

[6]  Stanley B. Block.  Are “Real Options” Actually Used in the Real World? , 2007 .

[7]  Paula F. V. Ferreira,et al.  Real Options versus Traditional Methods to assess Renewable Energy Projects , 2014 .

[8]  Robert J. Kauffman,et al.  Technology competition and optimal investment timing: a real options perspective , 2005, IEEE Transactions on Engineering Management.

[9]  José Arnaldo Barra Montevechi,et al.  Evaluating Energy Sector Investments: Calculating Volatility , 2013 .

[10]  Gerhard Schembecker,et al.  Real option framework for equipment wise expansion of modular plants applied to the design of a continuous multiproduct plant , 2015 .

[11]  K. Lai,et al.  An integrated real options evaluating model for information technology projects under multiple risks , 2009 .

[12]  Hemantha S. B. Herath,et al.  EXPLOITING UNCERTAINTY—INVESTMENT OPPORTUNITIES AS REAL OPTIONS: A NEW WAY OF THINKING IN ENGINEERING ECONOMICS , 2000 .

[13]  M. Gordon,et al.  Capital Equipment Analysis: The Required Rate of Profit , 1956 .

[14]  Paula F. V. Ferreira,et al.  The use of real options approach in energy sector investments , 2011 .

[15]  Nicole Propst.  Real Options Managing Strategic Investment In An Uncertain World , 2016 .

[16]  Fotios C. Harmantzis,et al.  Investment decisions in the wireless industry applying real options , 2007 .

[17]  Stewart C. Myers,et al.  Finance Theory and Financial Strategy , 1984 .

[18]  Neal Lewis,et al.  Breakeven Volatility for Real Option Valuation , 2014 .

[19]  David Zilberman,et al.  Innovation subsidies versus consumer subsidies: A real options analysis of solar energy , 2016 .

[20]  Nicola Secomandi,et al.  Real Options and Merchant Operations of Energy and Other Commodities , 2014, Found. Trends Technol. Inf. Oper. Manag..

[21]  Pierluigi Mancarella,et al.  A critical review of Real Options thinking for valuing investment flexibility in Smart Grids and low carbon energy systems , 2016 .

[22]  R. McDonald,et al.  Investment and the Valuation of Firms When There Is an Option to Shut Down , 1985 .

[23]  Venkat Allada,et al.  Evaluating Product Plans Using Real Options , 2007 .

[24]  Nalin Kulatilaka,et al.  Real Options Pricing and Organizations: The Contingent Risks of Extended Theoretical Domains , 2004 .

[25]  Luiz E. Brandão,et al.  Valuing the switching flexibility of the ethanol-gas flex fuel car , 2010, Ann. Oper. Res..

[26]  P. Kort,et al.  Volume flexibility and capacity investment under demand uncertainty , 2016 .

[27]  T. Copeland.  Real Options: A Practitioner's Guide , 2001 .

[28]  Bhagwan Chowdhry,et al.  Resources, real options, and corporate strategy , 1998 .