Real Options Valuation: a Monte Carlo Simulation Approach 1

This paper provides a valuation algorithm based on Monte Carlo simulation for valuing a wide set of capital budgeting problems with many embedded real options dependent on many state variables. Along the lines of Gamba and Trigeorgis (2002b), we decompose a complex real option problem with many options into a set of simple options, properly taking into account deviations from value additivity due to interaction and strategical interdependence of the embedded real options, as noted by Trigeorgis (1993). The valuation approach presented in this paper is alternative to the general switching approach for valuing complex option problems (see Kulatilaka and Trigeorgis (1994) and Kulatilaka (1995)). The numerical algorithm presented in this paper is based on simulation, and extends the LSM approach presented in Longstaff and Schwartz (2001) to a multi-options setting in order to implement the modular valuation approach introduced in Gamba and Trigeorgis (2002). We provide also an array of numerical results to show the convergence of the algorithm and a few real life capital budgeting problems, including the extension of Schwartz and Moon (2000,2001) for valuing growth companies, to see how they can be tackled using our approach. JEL Classification: C15, C63, G13, G31.

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