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A practical analytical model for valuing early stage investments using real options

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  • Yuri Lawryshyn

Abstract

In this work, we build on a previous real options approach that utilises managerial cash-flow estimates to value early stage project investments. Through a simplifying assumption, where we assume that the managerial cash-flow estimates are normally distributed, we derive a closed-form solution to the real option problem. The model is developed through the introduction of a market sector indicator, which is assumed to be correlated to a tradeable market index and drives the project's cash-flow estimates. In this way we can model a cash-flow process that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash-flow in a financially consistent manner under the risk-neutral minimum martingale measure. The method requires minimal subjective input of model parameters and is very easy to implement.

Suggested Citation

  • Yuri Lawryshyn, 2016. "A practical analytical model for valuing early stage investments using real options," International Journal of Operational Research, Inderscience Enterprises Ltd, vol. 25(4), pages 475-486.
    • Handle: RePEc:ids:ijores:v:25:y:2016:i:4:p:475-486
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