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Multiple Volatility Real Options Approach to Investment Decisions Under Uncertainty

Author

Listed:
  • Atul Chandra

    (School of Business and Law, Edith Cowan University, Perth, Western Australia 6027, Australia)

  • Peter R. Hartley

    (Department of Economics, Rice University, Houston, Texas 77005)

  • Gopalan Nair

    (Department of Mathematics and Statistics, The University of Western Australia, Perth, Western Australia 6009, Australia)

Abstract

We present a novel multiple volatility real options approach ( MVR ) to value investment projects with embedded flexibility and affected by multiple uncertainties. A core innovation is the MVR decision tree composed of MVR synthetic tree components , each reflecting a unique binomial process that approximates a geometric Brownian motion of project value induced by one uncertainty source. MVR uses Monte Carlo simulation to generate volatility of project value log-returns arising from each uncertainty source. MVR produces a multidimensional surface, which is hidden in other approaches, representing enhanced net present value (ENPV) as a function of each uncertainty. It allows the impact of each uncertainty’s volatility on ENPV to be measured through three MVR sensitivity analysis levers . To illustrate MVR, it is applied to a real-world investment project, revealing that MVR provides a more accurate valuation than alternative approaches that do not account for separate impacts of each uncertainty. MVR with its greater veracity, provides robust investment decisions through MVR decision rules.

Suggested Citation

  • Atul Chandra & Peter R. Hartley & Gopalan Nair, 2022. "Multiple Volatility Real Options Approach to Investment Decisions Under Uncertainty," Decision Analysis, INFORMS, vol. 19(2), pages 79-98, June.
    • Handle: RePEc:inm:ordeca:v:19:y:2022:i:2:p:79-98
    DOI: 10.1287/deca.2021.0449
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    References listed on IDEAS

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