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Applying Real Option Analysis with NPV-Embedded Binomial Trees

In: A Pragmatic Guide to Real Options

Author

Listed:
  • Tom Arnold

Abstract

In the first two chapters, net present value (NPV) analysis was demonstrated to be a very limited way to analyze the viability of a project, and it was shown that making decisions more sequential rather than a full commitment of capital at the start of a project creates value due to the ability to limit losses (or possibly by expanding the project when the opportunity presents itself). In the previous two chapters, binomial tree techniques were introduced to provide a probability distribution of the future value of an underlying asset (generally a stock) in order to price options or an option-like contract. The binomial tree can be used with a risk-adjusted discount rate (risk-adjusted pricing) or with the risk-free rate (risk-neutral pricing) to generate an option’s value. Risk-neutral pricing is easier to execute, but risk-adjusted pricing may be more “agreeable” to a decision-maker who is suspicious of using a risk-free rate to discount cash flows for a project that is risky.

Suggested Citation

  • Tom Arnold, 2014. "Applying Real Option Analysis with NPV-Embedded Binomial Trees," Palgrave Macmillan Books, in: A Pragmatic Guide to Real Options, chapter 0, pages 85-115, Palgrave Macmillan.
    • Handle: RePEc:pal:palchp:978-1-137-39116-2_5
    DOI: 10.1057/9781137391162_5
    as

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