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Valuing real options: frequently made errors

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  • Fernández, Pablo

    (IESE Business School)

Abstract

In 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.

Suggested Citation

  • Fernández, Pablo, 2002. "Valuing real options: frequently made errors," IESE Research Papers D/455, IESE Business School.
    • Handle: RePEc:ebg:iesewp:d-0455
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    References listed on IDEAS

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    1. 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, June.
    2. 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.
    3. Aswath Damodaran, 2000. "The Promise Of Real Options," Journal of Applied Corporate Finance, Morgan Stanley, vol. 13(2), pages 29-44, June.
    4. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
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    Cited by:

    1. Leh-Chyan So, 2014. "Are Real Options "Real"? Isolating Uncertainty From Risk In Real Options Analysis," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 9(01), pages 1-18.
    2. So, Leh-chyan, 2013. "Are Real Options “Real”? Isolating Uncertainty from Risk in Real Options Analysis," MPRA Paper 52493, University Library of Munich, Germany.
    3. 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, University of Reading.

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    Keywords

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    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; Personnel Economics - - Business Economics - - - Business Economics

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