OVERVIEW

Discounted cash flows (DCFs), simulations, and decision trees are relatively easy methods to understand, because the theoretical framework behind these methods is rather simple and requires no more than freshman college mathematics. DCF and decision tree analyses are also relatively easy from a computational standpoint; a handheld calculator will suffice. Simulations, however, will take enormous time with a handheld calculator and require special software because of the hundreds of simulations involved. Real options analysis (ROA) is far more complex compared to these traditional tools and requires a higher degree of mathematical understanding. The theoretical framework of real options solutions is complex, whereas the calculations involved are relatively simple. Once the equations for the options solution are formulated, the computations can be done easily with a handheld calculator.

In this chapter, commonly used methods to solve real options valuation problems are introduced. We do not delve into the theoretical basis and the derivation of the solutions; focus is on the application. There are several books that you can refer to for a better understanding of the concepts and mathematics behind the theory. Since the objective of this book is to help the practitioner, we have excluded detailed theoretical discussions.

There seems to be a false notion within the practicing community that real options valuation is a substitute for the DCF method. This is far from the truth. It is paramount that the practitioner first understand that ROA is not a substitute for but a supplement to DCF for...