A real option in its simplest form is a right with no obligation to invest in a project at a later time. A deferral option is an American call option with a right to delay the start of a project. An expansion option is also an American call that gives the owner the right to scale up a project. Abandonment and contraction options are American puts where the owner holds the right to terminate or scale down a project by selling all or some of its assets, respectively. An option has value because there is market uncertainty related to the underlying asset. The idea is that once the uncertainty clears, the option may be exercised and the project initiated, expanded, scaled down, or abandoned accordingly. The option lets you take advantage of the upside while avoiding the downside.

In the previous chapter, we illustrated how to use the binomial technique to value projects embedded with the aforementioned simple options. In this chapter, real options solution methods are presented for more complex project scenarios dealing with compound and rainbow options and options where volatility of the asset value changes during the option life. Also illustrated in this chapter is how real options analysis can be integrated with decision tree analysis in order to account for both market and private risks in the overall project valuation. As in the previous chapter, first the options example problem is framed, then a step-by-step method is presented to calculate the real options value...