Page 237 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 14.2.3 Valuation Inputs

Given the similarity in valuation approach, the inputs required for modelling the real option
correspond, generically, to those required for a financial option valuation. The specific
application, though, is as follows:
The option’s underlying is the project in question – it is modelled in terms of:
1. Spot Price: The starting or current value of the project is required: this is usually based on
management’s “best guess” as to the gross value of the project’s cash flows and resultant
NPV;

2. Volatility: Volatility uncertainty as to the change in value over time is required:
The volatility in project value is generally used, usually derived via monte carlo
simulation; sometimes the volatility of the first period’s cash flows are preferred;

Project NPV is often difficult to estimate, and some analysts therefore substitute a
listed security as a proxy, using either the volatility of the price of the security
(historical volatility), or, if options exist on this security, their implied volatility.

Option Characteristics
These are as follows:

1. Strike Price: This corresponds to any (non-recoverable) investment outlays, typically the
prospective costs of the project. In general, management would proceed (i.e. the option
would be in the money) given that the present value of expected cash flows exceeds this
amount.

2. Option Term: The time during which management may decide to act, or not act, corresponds
to the life of the option. As above, examples include the time to expiry of a patent, or of the
mineral rights for a new mine.

3. Option Style and Option Exercise: Management’s ability to respond to changes in value is
modeled at each decision point as a series of options, as above these may comprise, i.e.:

The option to contract the project (an American styled put option);
The option to abandon the project (also an American put);
The option to expand or extend the project (both American styled call options);

Switching options, composite options or rainbow options which may also apply to
the project.

14.2.4 Valuation Methods

The valuation methods usually employed, likewise, are adapted from techniques developed for
valuing financial options. Note though that, in general, while most “real” problems allow for
American style exercise at any point (many points) in the project’s life and are impacted by
multiple underlying variables, the standard methods are limited either with regard to
dimensionality, to early exercise, or to both. In selecting a model, therefore, analysts must make
a trade off between these considerations; The model must also be flexible enough to allow for
the relevant decision rule to be coded appropriately at each decision point.

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