Diane M. Lander

Challenges to the Practical Implementation of Modeling and Valuing Real Options

A great deal of theoretical work exists on how to model and value investment opportunities having real options. To date, this work has provided new insights into capital budgeting decision-making and a new decision-making framework. However, the currently proposed real option models are not widely used by corporate managers and practitioners. The question is, Why not? This paper posits one possible answer to that question. Specifically, this paper reviews what has been accomplished in modeling and valuing real options and examines practical implementation problems associated with the real option approach. The issues examined are: (1) the types of models currently used are not well known or understood by corporate managers and practitioners, (2) the required modeling assumptions are often violated in a practical real option application, and (3) the necessary additional assumptions required for mathematical tractability limit the scope of applicability. We then discuss possible alternatives for modeling and valuing real options that capture the essence of the problem, but do so in a simpler framework. This paper demonstrates the need to identify and develop alternative frameworks for practically modeling and valuing options.

A real options approach to valuing strategic flexibility in uncertain construction projects

To maximize project value, managers of construction projects must recognize, plan for and strategically manage uncertainty. Current construction planning, estimating, and management practices regarding uncertainty can undervalue projects by failing to exploit opportunities to increase project value, as well as minimize risks. Dynamic uncertainties are described as project conditions that cannot be resolved adequately through improved description or planning for pre-project strategy selection. A real options approach is proposed for proactively using strategic flexibility to recognize and capture project values hidden in dynamic uncertainties. An example of a proposal for a toll road project demonstrates a method of valuing managerial flexibility to evaluate and select strategies. Impacts of real options in other domains, along with this example, are the basis for concluding that using a structured real options approach in construction management can increase returns through improved project planning and management. Potential impacts of the use of real options are discussed, and challenges in valuing real options in construction projects are identified as the basis for future research.

Strategic Implications of Valuation: Evidence from Valuing Growth Options

Strategy is ultimately aimed at creating shareholder value. We examine the relationship among intrinsic (DCF) value, market value, and the value of growth options using a “perfect foresight” model. Our findings suggest that Kesters (1984) initial assessment of growth option values may not hold under alternative valuation models. We highlight important issues in the valuation of growth options related to market expectations, modeling assumptions and estimation methods. The findings suggest that the firms growth option value depends on three factors, each of which impacts investor expectations: (1) the macroeconomic environment; (2) the industry in which the firm participates; and (3) firm specific factors.

The DCF Approach to Capital Budgeting Decision-Making

Publisher Summary In the capital budgeting process, management must decide which long-term and, often times, high dollar assets the firm is going to acquire. Such decisions are based both on the firms strategic plan and expectations as well as the resulting asset valuations and risk assessments. The assets management decides to acquire may be purchased intact from other firms for a price or they may be manufactured in-house for a building cost. Finance academicians have long proposed that corporate managers use a Discounted Cash Flow (DCF) approach for making capital budgeting decisions. This traditional valuation framework ties directly to finance theory, where the objective of corporate management decision-making is stated to be maximize the value of the firm; and focuses on what finance considers to be the most, maybe even the only, important valuation factor—the Present Value (PV) of expected cash flows. The DCF approach to capital budgeting is mathematically relatively straightforward and results in determining the net value of a project, in todays dollars, adjusted for risk. A six-step DCF valuation process is also described in the chapter very briefly.