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Embedding a net present value analysis into a binomial tree with a real option analysis

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  • Tom Arnold
  • Timothy Falcon Crack
  • Adam Schwartz

Abstract

A net present value (NPV) analysis with associated financial statements is embedded into a binomial tree that allows the analysis to evolve through time and, at any given moment in time, to vary with different states of the world. The modeling of the cash flows within the binomial tree requires a variable component based on relationships with a specifically defined random variable and a component that is fixed at a given moment in time. Although after‐tax operating cash flows are used in this treatment with a real options example, the binomial tree method can be applied to other definitions of project cash flows.

Suggested Citation

  • Tom Arnold & Timothy Falcon Crack & Adam Schwartz, 2022. "Embedding a net present value analysis into a binomial tree with a real option analysis," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 43(7), pages 2924-2934, October.
    • Handle: RePEc:wly:mgtdec:v:43:y:2022:i:7:p:2924-2934
    DOI: 10.1002/mde.3572
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    References listed on IDEAS

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    1. James E. Hodder & Antonio S. Mello & Gordon Sick, 2001. "Valuing Real Options: Can Risk‐Adjusted Discounting Be Made To Work?," Journal of Applied Corporate Finance, Morgan Stanley, vol. 14(2), pages 90-101, June.
    2. Tom Arnold, 2014. "A Pragmatic Guide to Real Options," Palgrave Macmillan Books, Palgrave Macmillan, number 978-1-137-39116-2.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    4. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
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