An assessment of the option to reduce the investment in a project by the binomial pricing model

Abstract

Real options are a powerful complement to traditional methods of investment project assessment, such as the Net Present Value, when the value of some business strategies has to be included. This paper presents a methodology to calculate the value of the real option to reduce the productive capacity of an investment project within one, two, and n periods. It is well known that the option to reduce quantifies the value of the operational flexibility available to protect a business against possible losses generated by the project; its common use in business practice explains the relevance of developing a clear and easy-to-use tool to assess its value. Thus, to derive its value, the procedure implemented here consists of obtaining a mathematical expression for each of the aforementioned periods, based on a detailed construction of every possible future scenario and its associated probability by the multiplicative binomial method. This is a useful contribution to business practice as it provides a well-defined model to assess the strategic value of an investment project including the option to reduce its productive capacity. Moreover, this real option increases the project value by improving its initial level of feasibility.