Applicative model for appraisal of investment projects based on real options methodology

Abstract

This paper deals with the application of real options methodology on valuation of investment projects. The basic objective of the paper is to present applicative project valuation model, which enables decision-makers to build-up conventional NPV analysis by incorporating key input random variables, by using Monte Carlo simulation, and managerial flexibilities, by defining if-then decision rules. In contrast to most of valuation procedures covered in the literature, presented applicative model accepts simple premise that the project value is unknown in advance. Project value is not displayed with a single NPV number, but with the cumulative probability distribution. Final managerial decision does not depend on fixed decision rules, but on managerial aversion towards risk, i.e. on subjective trade-off between project risks and returns.