Valuing real options: frequently made errors
AbstractIn this paper we analyze frequently made errors when valuing real options. The best way of doing it is through examples. We start by analyzing Damodaran's proposal to value the option to expand the business of Home Depot. Some of the errors and problems of this and other approaches are: - Assuming that the option is replicable and using Black and Scholes' formula. - The estimation of the option's volatility is arbitrary and has a decisive effect on the option's value. - As there is no riskless arbitrage, the value of the option to expand basically depends on expectations about future cash flows. However, Damodaran assumes that this parameter does not influence the option's value (he does not use it) because he assumes that the option is replicable. - It is not appropriate to discount the expected value of the cash flows at the risk-free rate (as is done implicitly when Black and Scholes' formula is used) because the uncertainty of costs and sales at the exercise date may be greater or less than that estimated today. - Damodaran's valuation assumes that we know exactly the exercise price. - Believing that options' value increases when interest rates increase. - "Playing" with volatility. - Valuing contracts as real options when they are not.
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Bibliographic InfoPaper provided by IESE Business School in its series IESE Research Papers with number D/455.
Length: 24 pages
Date of creation: 20 Jan 2002
Date of revision:
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- M21 - Business Administration and Business Economics; Marketing; Accounting - - Business Economics - - - Business Economics
This paper has been announced in the following NEP Reports:
- NEP-ACC-2002-11-18 (Accounting & Auditing)
- NEP-ALL-2002-11-18 (All new papers)
- NEP-CFN-2002-11-18 (Corporate Finance)
- NEP-RMG-2002-11-18 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Grenadier, Steven R. & Weiss, Allen M., 1997. "Investment in technological innovations: An option pricing approach," Journal of Financial Economics, Elsevier, vol. 44(3), pages 397-416, June.
- Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
- Martha Amram & Nalin Kulatilaka, 2000. "Strategy And Shareholder Value Creation: The Real Options Frontier," Journal of Applied Corporate Finance, Morgan Stanley, vol. 13(2), pages 15-28.
- Aswath Damodaran, 2000. "The Promise Of Real Options," Journal of Applied Corporate Finance, Morgan Stanley, vol. 13(2), pages 29-44.
- Robert Fourt & Gianluca Marcato & Charles Ward, 2007. "Real Option Pricing in Mixed-use Development Projects," Real Estate & Planning Working Papers rep-wp2007-09, Henley Business School, Reading University.
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