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Implementing Real Options Valuation under Macroeconomic Risk and Normally Distributed Cash Flows

Author

Listed:
  • Norvald Instefjord

    (Redear of Finance, Essex Business School, Essex University, Wivenhoe Park, Colchester CO43SQ, England)

  • Turalay Kenc

    (INCEIF University, Jalan Tun Ismail, Kuala Lumpur, 50480 Kuala Lumpur, Wilayah Persekutuan Kuala Lumpur, Malaysia)

Abstract

The paper highlights the encountered problems in implementing real options under more realistic assumptions such as business cycle risk and normally distributed cash flows. The problems considered include (i) estimating empirical distribution of cash flows from real option investments; (ii) investment decisions across business cycles, and (iii) calculating the probability of investing with the above stated rich features. To this end, we estimate operating cash flows of US corporate firms using a Markov chain model under both geometric and arithmetic Brownian motions assumptions for cash flows and develop a valuation model of real option with normally distributed cash flows. Associated investment valuation models incorporating these estimates reveal that critical cash flow levels significantly differ across models and regimes.

Suggested Citation

  • Norvald Instefjord & Turalay Kenc, 2024. "Implementing Real Options Valuation under Macroeconomic Risk and Normally Distributed Cash Flows," International Econometric Review (IER), Econometric Research Association, vol. 16(1), pages 50-67, June.
    • Handle: RePEc:erh:journl:v:16:y:2024:i:1:p:50-67
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    More about this item

    Keywords

    Macroeconomic Risk; Regime Switching; Real Options; Arithmetic Brownian Motion; Geometric Brownian Motion;
    All these keywords.

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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