Combining Real Options and
Decision Tree: An Integrative
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JUNKUI YAO
is a postgraduate student in
the Project Management
Research Program at the
University of Sydney.
ALI JAAFARI
is a professor of project
management in the Project
Management Research
Program at the University
of Sydney.
a.jaafari@pmoutreach.usyd.edu.au
FALL 2003
Approach for Project Investment
Decisions and Risk Management
JUNKUI YAO AND ALI JAAFARI
rojects may be classified in terms of
P
inherent project complexity (e.g.,
realization of new technology) and
the associated market (environment)
uncertainties (e.g., profitability and general
market return on investment). The first types
are said to be diversifiable risks in the sense
that management can avoid the same by not
proceeding with the project or put in place
measures that can mitigate these risks or resolve
relevant uncertainties beneficially in stages of
development. The second types are referred
to as non-diversifiable risks, since these are
generally beyond management’s control.
Exhibit 1 shows a project classification based
on these two variables. The approach to risk
and uncertainty management must be shaped
according to the project complexity and envi-
ronmental uncertainties present in each case.
A project that seeks to upgrade the production
facilities in a well-established manufacturing
plant, with a defined scope and budget, has
virtually no environmental uncertainty com-
pared to an R&D project that is dependent
on both proof of a new technology and cre-
ation of a new market (customer needs and
acceptance). Exhibit 2 shows typical projects
and risk and uncertainty management tech-
niques that will suit them.
The emphasis in this article is on appraisal
and risk management of Type 3 and Type 4
projects and development and application of
a unique technique that combines decision
tree mapping with the real options valuation
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE
technique. However, it must be noted that the
challenge for the project team and project
manager on such projects is to reduce project
complexity/uncertainties progressively and to
align the project to the prevailing market
dynamics (by exercising appropriate options).
So it is natural to expect that projects should
move from Type 4, to 3, to 2, and even to 1
as they progress from conception to comple-
tion. Some of the uncertainties may be resolved
by way of either legislation/permits (as in most
major industrial and or infrastructure projects)
or through signing of commercial contracts to
transfer the relevant risks (as of power supply
projects).
Traditional risk analysis techniques typ-
ically develop models based on the discounted
cash flow (DCF) approach for project invest-
ment decision-making. DCF is not new and
has been applied widely to judge the worth of
a given project opportunity or for comparison
of alternatives. While it works satisfactorily
with a well-defined project in an environment
of reasonable certainty, its application in other
situations is not always successful as it assumes
a projected orderly development and a go/no-
go decision approach to the whole of a project
at the time of project feasibility studies and
approval. Most risky projects need decision
flexibility so that management can monitor the
progress of the project and then attempt to
make decisions that add value to the project.
If the evaluation shows that the project is
adversely exposed to risks because of insolvable
53
 EXHIBIT 1
Classification of Projects in Terms of Project
Complexity and Environmental Uncertainty
Complex
Complex/
Certain
Increasing project
Project Complexity
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complexity
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Increasing environmental
Simple/
Certain
Simple
Certain
Environmental Uncertainty
project complexities and/or market or environmental
uncertainties, management may wish to defer, scale down,
stage, or even abandon the project to respond to the unfa-
vorable market situations. Conversely, if the project shows
real promise and risks are manageable/acceptable, then
management may decide to scale up or initiate new ven-
tures in different locations. These courses of action open
to the decision makers are referred to as real options. The
value of the project will be affected by the identification
and exercise of the real options.
The project risk management processes contained in
PMBOK 2000 (PMI [2000]) show improvement over those
in its 1996 version in that the new processes place more
emphasis on risk monitoring and control. Still, it is neither
proactive nor dynamic, as it follows a plan-implement-
monitor process (Jaafari [2001]). The approach advocated
in most standards and best-practice PM models is focused
primarily on the project implementation phase and activ-
ities. Proactive project risk management requires an antic-
ipative approach that identifies and puts in place optimal
measures to manage project risks and uncertainties, mon-
itoring their movements, and responding to early warning
signs. Continuous and proactive risk management is essen-
tial for the success of all project types (Jaafari [2001]).
Real options analysis extends financial options theory
to options on real, or non-financial assets. The real option,
approach explicitly acknowledges the options or flexibil-
ities in a real project and the value of these options. The
54 COMBINING REAL OPTIONS AND DECISION TREE
philosophy behind the real options approach conforms
well to that of proactive risk management. The options
(flexibility) must be identified, planned, and monitored
to exercise in the process of a project as and when pre-
determined option conditions materialize. Thus, appli-
Complex/ cation of the real options approach not only presents a
Uncertain
more appropriate project evaluation than traditional DCF
methods do on risky and complex projects, but also results
in optimal project decision strategies. By adding an impor-
tant dimension of analytical flexibility, real options allow
for a better melding of project strategic value intuition
and analytical rigor.
In this research, the authors demonstrate that the
real options approach can be used as a clear and simple
complexity method to integrate appropriate project evaluation with
Simple/
optimal project management strategy in a bid to avert or
Uncertain reduce project risks from the perspective of a real proj-
ect. The method introduced by this research overcomes
Uncertain
the application limits implied in most real options litera-
ture that evaluates a specific project from a perspective of
the overall investment market, and considers only market
risks that a project may face.
REVIEW OF REAL OPTIONS LITERATURE
Dixit and Pindyck, in their book Investment Under
Uncertainty [1994], have highlighted the drawbacks of the
historical net present value (NPV) approach to capital
investment decisions. They have shown that the NPV
approach does not adequately and explicitly consider man-
agement’s ability to influence project outcomes through
such measures as delay, staged development, or other
appropriate responses to deal with uncertainty on capital
projects. The cost associated with losing the opportunity
to wait for additional information before taking a major
investment decision was shown to have a significant effect
on the value of a potential investment. These authors have
shown how techniques using “dynamic programming”
(DP) and “contingent claims analysis” (CCA) can incor-
porate the above factors. Uncertainties were represented
as stochastic processes. Financial options were shown to
represent the irreversible and flexible investment oppor-
tunities for a firm, and techniques of DP and CCA were
shown to be useful for valuation of such options.
Trigeorgis, in his book Real Options: Managerial Flex-
ibility and Strategy in Resource Allocation [1996], has pre-
sented an advanced discussion of the drawbacks of
traditional capital budgeting methods. He has shown how
to quantify the value of flexibility in capital budgeting
FALL 2003
 EXHIBIT 2
Project Classification and Nomination of Suitable Risk and Uncertainty Management Techniques

Project type and Examples Risk and uncertainty management techniques

characterization
Type 1: Simple-certain A standard building project Quality management, design coordination, project
to a client order, management, cost planning and control, discounted cash
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manufacture to a proven flow analysis, sensitivity analysis

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design, installation of
equipment
Type 2: Simple-uncertain Building a new amusement
center, residential
(speculative) development,
fashion products, training
schemes
Type 3: Complex-certain R&D projects, new
pharmaceuticals/materials,
automated (robotic) new
production facility
Type 4: Complex-uncertain 3G communication network,
e-banking and trading
systems, space stations,
supersonic jet liners
As above plus risk analysis evaluation techniques such as
decision tree, Monte Carlo simulation of IRR or NPV, unit
cost simulation, and analysis of market competitiveness
As Type 1 plus decision tree, Monte Carlo simulation of
IRR, NPV, unit cost simulation, unit cost competitiveness,
real options. The emphasis is on measuring the sensitivity
(variance) due to the fluctuations in the components of the
project and the associated interrelationships (less worries
on environmental effects and complexities)
As type 1 plus real options, combined soft and hard
assessment of project potential, multi-criteria and
preference modeling, end product testing and piloting

with both discrete-time and continuous-time models.
Trigeorgis uses a binomial model to mimic the uncer-
tainties of the future cash inflows of the underlying proj-
ect in the discrete time model, where the uncertainties
associated with the project cash inflows are unfolded in a
time-by-time manner. Also, he uses a stochastic process
to represent continuous uncertainties.
Mitchell and Hamilton [1988] have presented an
approach for “managing R&D as a strategic option”
(strategic positioning) by treating a current R&D project
as financially directed toward creation of an option on a
potentially profitable follow-up investment for a future
project. They show the value of the option to be depen-
dent on identification of strategic objectives and posi-
tioning targets and impacts of strategic options.
Chatterjee and Ramesh [1999] have presented a
concept of the application of real options in the adoption
of technological innovations. They argue that real options
FALL 2003
can be identified in the form of opportunity to invest in
a currently available innovative project with an additional
consideration of the strategic value associated with the
possibility of future and follow-up investments stemming
from the emergence of another related innovation in
future. With their concept, they present a risk-driven pro-
cess framework for risk management of software projects.
Benaroch and Kauffman [2000] use option pricing
models (OPM) to assess flexible investment opportunities
in light of market uncertainties. For investment oppor-
tunities that can be delayed, they found the significant
value of the ability to wait for further information and
thereby avoid potential losses to be absent in the NPV
approach.
Similar applications of real option techniques to
problems related to capital investments, operational strate-
gies, etc. also can be found in published literature.
McDonald and Siegel [1986] have evaluated the flexi-
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 55
 bility to defer the commitment of resources to a project
until more information about the project outcomes is
available. Majad and Pindyck [1987] have evaluated the
flexibility to stage a project. They have shown how a
multi-stage project, whose construction involves a series
of cost outlays, can be shut down temporarily and resumed
or even killed in its course if new information is unfa-
vorable. Myers and Majad [1990] have evaluated the flex-
ibility of abandoning a project, where market conditions
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get so bad that the resources of the project can be sold only
for their salvage value. McDonald and Siegel [1985] also
have analyzed the value of altering the operating scale of
the project, which can be expanded or contracted or even
shut down temporarily and restarted depending on the
market conditions.
Real option literature is focused mostly on the appli-
cation of the technique to capital investments and opera-
tional strategies. The real option approach is used as a
method to account for the uncertainties related to the market
return of real projects. But such a market investment per-
spective cannot give a proper value that accounts for both
project implementation uncertainties and market return
uncertainties in evaluating a real project (as in an R&D proj-
ect). The market investment perspective, borrowed from
financial options theory, holds that project-specific risks can
be diversified away by holding a portfolio of assets (projects);
thus no compensation for project-specific risks is needed in
evaluation decisions. But from an owner’s perspective, both
project-specific risks and market risks must be accounted
for properly in real project evaluation.
Projects inevitably involve unique uncertainties. In
this research, the authors have explored the application of
the real options concept combined with decision tree anal-
ysis (DTA) to evaluate a project from a real project’s per-
spective. Decision tree analysis permits mapping of project
options coupled with associated market uncertainties.
Thus, project evaluation incorporates the consideration
of both market and project-specific uncertainties. The
method proposed overcomes the drawbacks of the tradi-
tional NPV-like approaches as well as that of pure appli-
cation of financial options theory to real projects.
TRADITIONAL PROJECT APPRAISAL
METHODS
The traditional project appraisal methods can be
divided into two categories: discounted cash flow (DCF)
methods and non-DCF methods. The non-DCF methods
include payback period analysis (PBP) and average rate of
56 COMBINING REAL OPTIONS AND DECISION TREE
return (ARR). The main drawback in non-DCF methods
is that they all ignore the time value of money.
The payback period (PBP) is the number of years
required to recover the initial investment in a project. It
emphasizes liquidity and the risk position of the project.
where PBP is the payback period (years), P is the annual
profit in annuity form, and I is the amount of investment.
Accounting/average rate of return (ARR) is
designed to compute the percentage of expected return
on the project. It uses the accounting profit to measure
benefits of the project.
where ARR is accounting/average rate of return, Pi is
the annual project profit in year i, I is the amount of ini-
tial investment, and T is the life span of the project. ARR
is sometimes interpreted as return on investment (ROI).
Under the category of the DCF methods, a number
of techniques have been developed for the purpose of
investment appraisal. Among them, net present value
(NPV), internal rate of return (IRR), net future value
(NFV), and profitability index (PI) are used most widely.
PI is the ratio of the NPV over the net value of total cap-
ital investment at a given discount rate.
NPV nets the present value of the investment from
the present value of the benefit of the project (Turner
[1995]). A simple logic is often applied: Accept project if
NPV > 0 (at the given discount rate) and reject project
otherwise. NPV can be calculated as follows:
When the investment (I i ) is made at the beginning of the
period (t = 0), and k i , the discount rate at period t. If k i
is constant k, the formula will be:
FALL 2003

Where NPV is the net present value, NCFi is the net cash
flow from the project at period t = i, k is the opportu-
nity cost of capital rate (normally known as discount rate,
hence techniques that use discounting or compounding
of cash flow terms are classed as discounted cash flow methods),
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I 0 is the amount of investment, and T is the life span of
the project.
NPV considers all cash flows of the project and
accounts for the pattern and timing of the cash flows. But
it assumes an equal class of risks for both cash inflows and
outflows of the project, and accounts for risks with an ad
hoc discount rate k, which implicitly allows for both the
time value of the money and the risk premium of the
investment. The approach where NPV is estimated using
an adjusted discount rate that excludes the risk premium
is called the risk-adjusted NPV approach.
The internal rate of return (IRR) (McGuigan,
Moyer, and Harris [1996]) provides the rate of return that
the project will provide if it is accepted. It can be found
using the formula:
From the above expression the value k can be com-
puted; this is IRR, or the rate at which the net present
value equals zero.
If the initial investment is made at the beginning of
the period (t = 0), the formula will be:
Where IRR is the internal rate of return, NCFi is the net
cash flow from the project at period i, k is the discount
rate or for NPV = 0, k is equal to IRR, I0 is the amount
of investment, and T is the life span of the project.
IRR gives the return rate at which the project will
make no profit and no loss considering its projected rev-
enue and cost. Accept the project if its IRR exceeds the rate
of capital cost or the rate of return on comparable invest-
ments in the capital market or the relevant industry sector.
The discount rate, k, is the sum of the risk-free
FALL 2003
interest rate r used to discount for the time value of the
money (pure discount) and a discount risk premium, p,
used to compensate for the risks generally associated with
undertaking the project as opposed to depositing the funds
in a risk-free interest bearing account.
THE DEFICIENCIES OF
TRADITIONAL DCF METHODS
In the most traditional DCF appraisal, including
NPV analysis, the project’s expected cash flows are dis-
counted using a rate that reflects the following: 1) project
risks; 2) market risks associated with the project’s expected
sales and revenue stream; and 3) time-dependent value of
money, or the rate at which lending and borrowing takes
place freely. Market risks are known as non-diversifiable
risks in the sense that these are beyond management’s con-
trol. The higher the market risks, the higher the discount
rate used to discount the project’s cash flow. An alterna-
tive way to account for market risks (in place of loading
the discount rate in the NPV expression) is to treat project
cash flow terms as stochastic variables.
Project-specific risks are driven by factors other than
the market, and are the result of variability in factors unique
to the particular project or its host organization or other sit-
uational factors. Project-specific risks are known as diver-
sifiable risks; they can be handled via mapping and inclusion
of options together with their respective probabilities rather
than loading the discount rate in the NPV expression.
Project options are asymmetric in nature in the sense
that management can avoid or reduce losses and maximize
gains by intervening at the right time; so the chances of
positive outcomes are higher than negative outcomes. On
a typical project up to seven types of real options can be
exercised, e.g., option to defer a project until more infor-
mation is available, option to stage investment, option to
alter operating scale, option to abandon, and so on. It is
also important to analyze the interactions among mul-
tiple real options.
DCF methods are, however, unable to capture the
value of the operating options properly; this is because of
the discretionary asymmetric nature of future operating
options and their dependence on future events that are
uncertain at the time of the initial decision. Neither can
traditional DCF methods account for the project risks in
a transparent manner.
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 57
 As will be seen, the authors have used a risk-free TRADITIONAL APPROACHES
discount rate, r (at which borrowing or lending takes place DEALING WITH UNCERTAINTY
freely), to account for time-dependent value of money.
The project’s NPV under uncertainty can be cal- Sensitivity Analysis
culated the same way as that under certainty. The uncer-
The cash flow estimates used in capital budgeting to
tain cash flow in each year, NCFi , can be replaced by its
determine NPV are invariably derived from forecasts of
certainty-equivalent amount, bt , on the assumption that
other primary variables. Sensitivity analysis is the process
the certain cash flow in the year t has the same present
of delving into these forecasts to identify the key primary
value as the uncertain cash flow in that year. Thus, NPV
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variables and determine the impact on NPV of a given vari-

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under uncertainty can be written as:

ation in each key variable at a time, with other variables
held constant. Sensitivity analysis is useful in identifying the
crucial variables that could contribute the most to the mag-
nitude of uncertainty associated with an investment.
Sensitivity analysis has its limitations. It considers
the effect on NPV of only one error in a variable at a
Where r is the risk-free discount rate.
time, thus ignoring combinations of errors in many vari-
When expected return is used, with a constant dis-
ables simultaneously. In addition, examining the effect of
count rate for all project periods, the NPV is:
each variable in isolation is even less meaningful when
there are interdependencies among the variables, in which
case knowing the value of one variable would influence
the estimate of another.

E(NCF) is the expected value of the future uncertain cash Traditional Simulation
flow. This is equal to cash flow estimates times their respec-
Traditional simulation techniques use repeated
tive probability of occurrence.
random sampling from the probability distributions
The real world within which business decisions must
assigned to each of the crucial primary variables under-
be made is unavoidably characterized by risk and uncer-
lying the cash flow of a project to arrive at output prob-
tainty. Uncertainty is typically resolved gradually, and the
ability distribution or risk profiles of the cash flows or of
forecasting of cash flows is imperfect and subject to error.
NPV for a given management strategy. Simulation
Thus, risk and investors’ attitude toward it must be
attempts to imitate a real-world decision setting by using
accounted for in the process of capital budgeting, and
a mathematical model to capture the important functional
particularly in the NPV criterion. Under uncertainty, a
characteristics of the project as it evolves through time
future variable is characterized not by a single value but
and encounters random events, conditioned upon man-
by a probability distribution of its possible outcomes. The
agement’s pre-specified operating strategy. Monte Carlo
amount of dispersion or variability of possible outcomes
simulation is a frequently used form of traditional simu-
is a measure of how risky that uncertain variable is. The
lation. The simulation model can handle complex deci-
traditional NPV approach has long suffered from the dif-
sion problems under uncertainty with a large number of
ficulties associated with determining the discount rate k,
input variables, which even may interact with one another
which must account for the project risks and market return
or across time.
as well as time-dependent value of money.
Monte Carlo simulation is a forward-looking tech-
nique based on a predetermined (built-in) operating
strategy; as such, it may be an appropriate model for path-
dependent or history-dependent problems. However, it
is not well suited to accommodate the asymmetries in the
distributions introduced by management’s flexibility to
review its own preconceived operating strategy when it
turns out that, as uncertainty gets resolved over time, the

58 COMBINING REAL OPTIONS AND DECISION TREE FALL 2003

 realization of cash flows differs significantly from initial
expectations.
Process Simulation
Process simulation permits investigation of a project
concept in terms of its capability to generate the expected
units of output and thus the associated cash inflow terms
(Doloi and Jaafari [2002]). It also permits investigation of
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operating costs and the interrelationships among con-
stituent parts of the project. Broadly, a digital process of
a project first is set up in accordance with the relevant
operating strategy and performance of project parts. The
uncertainty in terms of operation and interrelationship
of project components can be incorporated into the pro-
cess model by assigning stochastic duration to the cycle
time of the respective components in the project process.
The process model then can be run digitally and relevant
statistics collected for further study.
Process simulation can be a precursor to pilot plant
operation. It yields valuable information regarding the
real-life performance of each project option. Its full poten-
tial as a tool for optimum configuration of a project or as
a tool for risk and uncertainty management remains to be
exploited. It is a powerful method to investigate many of
project uncertainties through random variation of the
performance (within a probable range and associated prob-
ability distribution) of the project constituent parts and
associated interrelationships that are difficult to model and
analyze mathematically.
Decision Tree Analysis (DTA)
One of the advantages of decision tree analysis
(DTA) is the facility it offers to structure the decision
problem by mapping out all feasible alternative manage-
rial actions contingent upon the actual market and envi-
ronment responses at the time of undertaking project
activities. As such, it is particularly useful for analyzing
complex sequential investment decisions when uncer-
tainty is resolved at distinct, discrete points in time.
Whereas conventional NPV analysis might be misused by
managers inclined to focus only on the initial decision to
accept or reject the project at the expense of subsequent
decisions being dependent on it, DTA forces manage-
ment to bring to the surface its implied operating strategy
and to recognize explicitly the interdependencies between
the initial decision and subsequent decisions.
In DTA, management need only make the current
FALL 2003
decision for the time being; however, management should
realize that the current choice will in effect determine
the feasibility and attractiveness of future events and pos-
sible later decisions. A decision at any stage can be long-
term optimal (in the light of possible later decisions) only
if all subsequent decisions are themselves optimal. Thus,
the optimal initial decision must be determined by starting
from the end of the tree and working backward to the
beginning. This dynamic search or roll-back procedure
involves determining at each status of a stage, as we move
backward, the expected discounted NPV by multiplying
all the NPV values calculated at the previous stages with
their respective probabilities of occurrence and summing
these up (see the example appearing later).
The problem that remains is how to determine an
appropriate discount rate. Using a constant discount rate
presumes that the risk borne per period is constant and
the uncertainty is resolved continuously at a constant rate
over time, not in discrete lumps; if discrete chance events
were appropriate, then different discount rates should be
used in different periods. Using a high discount rate may
be appropriate for the naked project (without options).
However, in the DTA its use would clearly undervalue the
project’s true worth when risk is reduced via an option
such as abandonment or guarantee.
REAL OPTIONS AND ASSET PRICING
A financial option is defined as the right, without
an associated obligation, to buy (if a call) or sell (if a put)
a specified asset (e.g., shares of common stock) at a pre-
specified price (the exercise or strike price) on or before
a specified date (the expiration or maturity date). If the
option can be exercised before maturity, it is called an
American option; if only at maturity, a European option.
The beneficial asymmetry derives from the right to exer-
cise an option only if it is in the option holder’s interest
to do so, with no obligation to do so if it is not. This flex-
ibility lies at the heart of an option’s value. Options differ
from futures contracts, which involve a commitment to
fulfil an obligation undertaken to buy or deliver an asset
in the future at terms agreed upon today whether the
holder likes it or not. Thus, unlike the potential payoff to
future contracts, which are symmetric with regard to up
or down movements of the underlying asset, the payoff
to options is asymmetric or one-directional.
Real options analysis extends financial options theory
to real, or non-financial assets. Analogously, a company
that has a real option has the right—but not the obliga-
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 59
 EXHIBIT 3
Types of Real Options That Project Investments Could Embed

Options Features of Project Investment

Defer Project that can be postponed allows learning more about potential project outcomes, as
a function of stochastic output prices and/or stochastic production costs, before making a
commitment.
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Stage A multi-stage project whose construction involves a series of cost outlays could be shut
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down temporarily and resumed, or even killed in midstream (if new information is
unfavorable), where project payoffs arrive only after the project is completed. Examples
include R&D projects, long development capital-intensive projects, and start-up
ventures.
Outsource Project development can be sub-contracted to a third party, to transfer the risk of "in-
house" failure.
Explore Start with a pilot (or prototype) project and follow up with a full-scale project if the
(Pilot / pilot succeeds. This can reduce the risk of unfavorable market demand of a new product.
Prototype)
Alter A project whose operating scale can be expanded or contracted, depending on market
Operating conditions, with the extreme case of shutting down temporarily and restarting when
Scale conditions become favorable. For example, when it is not optimal to keep a production
facility operating because stochastic revenues are not expected to cover variable costs,
management may have the option to shut down the project for a certain period until
Contract higher revenues are expected (Brennan and Schwartz [1985]; McDonald and Siegel [1985];
Expand Andreou [1990]). This type of managerial flexibility is important when choosing among
alternative production technologies with different ratios of variable to fixed costs.
Changes in a project's total output can be achieved by changing the output rate per unit
Shutdown time, by accelerating resource utilization, or by changing the total length of time the
Restart project is kept alive. Choosing to build production capacity in excess of the uncertain
expected demand provides the flexibility to produce more. Similarly, choosing to build a
plant with lower initial construction costs provides the flexibility to reduce the life of the
plant and shrink the project's scale by reducing maintenance expenditures.
Switch-Use Project can be abandoned permanently if market conditions worsen severely, so that
(Abandon) project resources could be sold or put to other more valuable uses (Myers and Majad
[1990]). The abandonment flexibility is important, for example, when choosing among
alternative production technologies with different purchase-cost to resell-cost ratios.
Lease Project resources can be leased, so that if project payoffs are too low, the project could
be cut at a minimal cost. Unlike the case of abandonment, breaking a lease (by failing to
make the next lease payment) could carry a pre-specified penalty term.

60 COMBINING REAL OPTIONS AND DECISION TREE FALL 2003

 EXHIBIT 3 (continued)
Types of Real Options That Project Investments Could Embed

Switch The project permits changing its output mix, or producing the same outputs using
Input/Output different inputs, in response to changes in the price of inputs and/or outputs. This option
is especially relevant to the utilization of flexible manufacturing systems (Kulatilaka
[1993]). Examples where the output can shift include industries in which the goods sought
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are in small batches or subject to volatile demand (e.g., consumer electronics, toys,
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machine parts, cars). Examples where inputs can shift include all feedstock-dependent
facilities (e.g., oil, electric power, and chemicals).
Compound Real-world projects involve two or more of the above options, where the value of an
earlier option can be affected by the value of later options ( Brennan and Schwartz [1985];
Kulatilaka [1993]; Trigeorgis [1993, 1996]).
Strategic A project that is a prerequisite or a link in a chain of interrelated projects, whereby it
Growth spawns future project opportunities (Kester [1984]). Examples include infrastructure-based
projects in industries with multiple product generations, industries exploring new
generation products or processes, industries involving entries into new markets, or
industries where the strengthening of core technological capabilities is of strategic
importance.

Source: Benaroch [2001].

tion—to make a potentially value-adding investment.
Investment examples include new plants, line extensions,
joint ventures, licensing agreements, and so on.
By adding an important dimension of analytical flex-
ibility, real options allow for a better melding of strategic
intuition and analytical rigor. Real option values and DCF
values are equal when one assumes that there are no
changes in managerial decisions across outcome ranges
and that cash flow forecasts equal the average of an
expected probability range. Further, as real option pricing
models rely heavily on financial market data, the frame-
work is closely aligned with the real world.
Real option thinking highlights the point that
strategic action often creates valuable options. Once iden-
tified, these options can be assessed and exercised (if appro-
priate). Although real options exist in most businesses,
they are not always easy to identify. Real options can be
classified into three main groups: invest/grow options,
defer/learn options, and disinvest/shrink options
(Copeland and Keenan [1998]). In turn, real options can
be defined further within these broader headings. It should
be noted that many real options in a project are interre-
lated, and there may be different kinds of options
embedded in one project. Some common real options
embedded in real projects have been identified by Tri-
georgis, McDonald, Siegel, Myers, and other authors.
Exhibit 3 shows these common real options.
There are two common approaches in evaluating
real options: Black-Scholes formula and binomial model.
Black-Scholes Option Pricing Model
The Black-Scholes (1973) formula values a Euro-
pean call or put option as follows:
Value of a Call:
(1)
Value of a Put:
(2)

FALL 2003 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 61

 Where: EXHIBIT 4
A Two-Step Binomial Model of the Price Movement
of an Underlying Asset
(3)
Suu
Cuu
(4)
Su

Cu Sud
S: The current price of the underlying asset S
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X: Exercise price Cud

r: Risk-free interest rate per annum at current
time, with continuous compounding, for
an investment maturing at time T
T: Time to expiration of the option
s: Standard deviation of the returns
N(.): Cumulative normal distribution function
The principal assumption behind the Black-Scholes
model is that returns are of lognormal distribution; besides,
there are a number of other assumptions (Galitz [1994]):
• The underlying asset can be bought and sold freely,
even in fractional units;
• The underlying asset can be sold short, and the pro-
ceeds are available to the short seller;
• The underlying asset pays no dividends or other dis-
tributions before maturity;
• Lending and borrowing is possible at the same risk-
free interest rate;
• The option is European style, and therefore cannot
be exercised prior to maturity;
• There are no taxes, transaction costs, or margin
requirements;
• The underlying price is continuous in time, with
no jumps or discontinuities; and
• Variability of underlying asset prices and interest
rates remain constant throughout the life of the
option.
C Sd
Cd Sdd
Cdd
cating portfolio that will create the same cash flows as the
underlying asset. The objective of establishing a portfolio
is to combine risk-free borrowing/lending and the under-
lying asset, with which the same cash flow as the option
being valued is created.
We create a replicating portfolio that consists of N
shares that have the same risk characteristics of the assets
and a borrowing of B at risk-free rate. After one year, the
asset price moves from S to either Su in the case of up
movement or Sd in the case of down movement, so the
option value C also moves to Cu or Cd respectively, under
which circumstances the replicating portfolio will generate
the same value as the option of holding the asset. Note
that multipliers d < 1, u > 1. Further, d < 1 + r < u.
So:

The Binomial Model

The binomial model has proven over time to be the

most flexible, intuitive, and popular approach to option
pricing (Benaroch [2001]). It is based on the simplifica- The value of the call option is:
tion that over a single period, the underlying asset price
can move from its current price only to two possible levels: (5)
up or down.
Exhibit 4 gives a two-step binomial model of the
price movement of an underlying asset. An option is With:
priced by the binomial model via bringing in the repli-

62 COMBINING REAL OPTIONS AND DECISION TREE FALL 2003

 EXHIBIT 5
Link Between Investment Opportunities and Black-Scholes Inputs

Investment Opportunity Variable in Options Call Option

Term

Present value of the project’s cash flow S Stock price

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Potential investment to be made X Exercise price

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Time the investment decision may be T Time to expiration

deferred

Time value of money r Risk-free rate of return

2
Potential uncertainty of the project Variance of returns on stock

price will go up and (1 – p) that it will go down.

The above example is the one-period binomial pro-
cess. By following the same logic, a multi-period bino-
Suppose that: mial tree can be valued. In that case, the evaluation
procedure starts with the last time period and moves back-
wards in time until the current point of time is reached.
The Black-Scholes formula and the binomial model
Thus: share similar assumptions. The Black-Scholes formula can
be derived from the binomial model. Although most real
(6) projects cannot meet all the requirements or assumptions,
evaluation using these methods produces a good approx-
Where: imation of the proper value.
C: the value of the option to hold the asset; In its general description, the real option valuation
Cu: the value of the option when the price of approach is an extension of financial options theory to
the asset is Su; options on real assets. Investment opportunities on a tan-
Cd: the value of the option when the price of gible project are similar to financial options. The link
the asset is Sd; between investment opportunities and Black-Scholes
r: the risk-free interest rate; inputs is show in Exhibit 5.
S: current price of the asset; Although real options are analytically robust, they
p: the risk-neutral probability; are best understood as a way of thinking. From a man-
u: the multiplier of the current price of the agement perspective, that means appreciating what types
asset for price up-movement; of options exist, how they can be created, how and why
d: the multiplier of the current price of the option values change, and how to capture their value. A
asset for price down-movement. real options analysis often provides answers that run
counter to the standard, and often limiting, NPV rule.
Equation 4 actually estimates the value of a Euro- Compared with the real options approach, the DCF
pean call option for one period by assuming that, under method represented by the NPV approach has the fol-
risk-neutral conditions, there is a probability of p that the lowing deficiencies (Mauboussin [1999]):
Flexibility: Flexibility is the ability to defer, abandon,
FALL 2003 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 63
 expand, or contract an investment. For example, a com-
pany may choose to defer an investment for some period
of time until it has more information on the market. The
NPV approach would value that investment at zero, while
the real options approach would correctly allocate some
value to that investment’s potential.
Contingency: This is a situation when future invest-
ments are contingent on the success of today’s investment.
Managers may make investments today—even those deemed
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to be NPV negative—to access future investment oppor-
tunities. Traditional capital budgeting models value these
option-creating investments inadequately. Pharmaceutical
company investments are a good example. Future spending
on drug development is often contingent on the product
clearing certain efficacy hurdles. This is valuable because
investments can be made in stages rather than all up-front.
Volatility: Somewhat counterintuitively, investments
with greater uncertainty have higher option value. In stan-
dard finance, higher volatility means higher discount rates
and lower net present values. In options theory, higher
volatility—because of asymmetric payoff patterns—leads
to higher option value (Benaroch [2001]). This means
that industries with high uncertainty actually have the
most valuable options.
Real option valuation (ROV) complicates the asset
(project) valuation method by requiring a search for the
best policies to manage the asset in the future. Moreover,
the possible dependencies of parts of the scenario tree on
future management actions become an important con-
sideration when more than one possible policy is to be
analyzed. In principle, a valuation can be done for each
contending policy as if it were the only one available. The
best strategies then can be found by comparing the
resulting values. If the trial valuations are costly to com-
pute (as is usually the case), a smart search strategy will
try to make the number of trial valuations required as
small as possible.
The search method most commonly used is dynamic
programming. The valuation begins at each end state on
the scenario tree, where the value is the terminal cash
flow. The algorithm then works back through the tree,
calculating, at each non-terminal state, the action or set
of actions at that state that gives the highest value, and
this value itself. The value generated by an action at a
state is the sum of the cash flows in that state from that
action and the value that comes from the asset value in
the states that immediately follow in the scenario tree.
In a combined ROV and DTA, the asset valuation
and the determination of the policy for future manage-
64 COMBINING REAL OPTIONS AND DECISION TREE
ment of the asset are done jointly. In these situations, the
DTA is applied as part of the analysis. In this research, the
decision payoffs on a DTA are valued using real option
methods together with appropriate handling of project-
specific risks through decision tree branches.
COMBINING DECISION TREE
WITH REAL OPTIONS VALUATION
As stated, the DTA method can be combined with
the real option approach: DTA provides the mapping of
decision-making options, while the real options approach
gives a technique for valuing the underlying cash flows of
the project. The method proposed by this research works
as follows: Assign distributions to cash flow terms to
account for market risks, and apply probabilities against
outcomes that are generated by respective activities on
the decision tree to account for project-specific risks.
Apply a risk-free discount rate of r as the risk-free rate at
which borrowing and lending can take place. By inte-
grating ROV and DTA, and treating market risks and
project-specific risks separately, the research proposes a
ready-to-use project evaluation approach that properly
accounts for all risks facing the project while incorpo-
rating the value of the options (flexibility) available during
the development and operating phases of the project.
This method is in line with normal project delib-
eration practices. The market risks that influence all sim-
ilar projects generally are analyzed by a market research
department or consultant of the firm and are driven by
the market factors beyond the control of a particular proj-
ect or firm. The return uncertainties associated with these
factors need to be monitored and re-evaluated when new
information becomes available. The implementation risks
are specific to the project, reflecting mainly the uncer-
tainties as to whether the project will deliver the desired
product or service that the project was undertaken to
address. Implementation risks are often managed by the
engineering department, as engineers can evaluate the
possibility of success for each status of the decision out-
come in this phase. A decision tree is built together with
the implementation risks evaluated by experienced engi-
neers who are most familiar with the project’s technical
issues. A project sales or revenue tree is built paralleling
the decision tree to depict the movements of possible rev-
enue outcomes. This arrangement gives a full picture of
both project revenue issues and implementation issues,
together with a decision mapping, which includes all the
information and its patterns.
FALL 2003
 EXHIBIT 6
A Project Decision Process With Embedded Options
Promising
Outcome
Invest in
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project
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Invest in
R&D
Unpromising
Outcome
Not Invest
Source: Neely and de Neufville [2001].
By analyzing every decision branch of the decision
tree using the real options approach, we can estimate the
real option value from each decision branch. For many
projects, the project revenue cannot be accessed unless all
the implementation phases go through successfully. Thus,
the option value of a given branch must be adjusted for
the probability of its implementation success. For those
branches where project implementation fails, we should
net the expected cost as the real option value. This method
is quite easy to use and robust for complex decision pro-
cesses and evaluation. Rather than multiplying all the
contingent event outcomes with their corresponding real
perspective probabilities, and summing the results to get
an expected value of the cash flow, the real option
approach explicitly acknowledges the flexibility to dis-
card the project if the conditions turn out to be worse than
expected. Exhibit 6 shows a decision process that embeds
abandon options. The management in this case has the
flexibility to cut the implementation cost if the R&D
project is a failure.
The following is an example that demonstrates how
DTA and ROA can be combined to evaluate a project
properly, including an optimum project strategy search.
Suppose a company is considering an R&D project invest-
ment. The project is broken down into three stages. The
first stage is to verify its underlying technology (innova-
tion) in t = 0 with a cost of $500,000. If the technology
is proven, then at t = 1, the company will spend $1,000,000
FALL 2003
Implement
Project Positive
Payoff
Stop
Project Lose R&D
Cost
Implement
Project
Negative
Payoff
Stop
Project Lose R&D
Cost
No Cost
No Pay
to build a prototype. The prototype then will be evalu-
ated by technicians and client representatives (e.g., sales
department). If the prototype is successful technically and
welcomed by the customer representatives, then the com-
pany will proceed with the project by investing
$10,000,000 to build a plant to manufacture the new
product in year two. These stages can be seen in Exhibit 7.
The events and their probability of occurrence are also
shown in this exhibit. If the last stage is reached, it is
expected that the project will generate either high,
medium, or low net cash flows in year three, with the
respective probabilities of occurrence of 0.3, 0.4, and 0.3
as indicated in Exhibit 7. For simplicity, the net cash flow
has been confined to year three. This example is simple
but typical of real project evaluation.
Traditional NPV under Decision Tree Analysis: Since the
decision tree presented in Exhibit 7 has given a full picture
of the project outcomes, with incorporation of both market
return uncertainties and project implementation uncer-
tainties, a risk-free discount rate should be used to com-
pute passive NPV. Assume that r = 8% per annum as the
risk-free interest rate at which free borrowing and lending
can be made.
For the high revenue branch, the net present value
discounted to year 0:
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 65
 EXHIBIT 7
The Investment Decision Tree and EPV Movements (Data in $000)

High
Build Demand $30,000k
Plant 0.3
$10,000k Medium $10,000
Success 0.4
Build 0.6
Prototype Low $2,000
$100k
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Demand
Success 0.3
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Verify 0.8 Failure Do not

Technology
0.4 Build
$500k
Do not
Failure Build
0.2

Do not Verify
uuu
uu
up
ud duu
EPV

down udd

dd
ddd

Year 0 1 2 3

Cost
500 1,000 10,000
30,000@ 0.3 probability
10,000@ 0.4 probability
2,000@ 0.3 probability

For the medium revenue branch, the net present

value discounted to year 0:

For the branch in which the prototype is a failure,

Bpf is the net present value discounted to year 0:
For the low revenue branch, the net present value dis-
counted to year 0:

66 COMBINING REAL OPTIONS AND DECISION TREE FALL 2003

 The net present value of the project using the stan-
dard decision tree will be:
Where I0 is the initial cost for verifying the technology
($500,000 in this case).
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Under traditional DTA analysis of the NPV, this
project will be rejected since the NPV < 0.
The above decision tree analysis assumes that the
project is left to pure chance with no management inter-
vention at different stages of prototype or full manufac-
ture decision points, which provide opportunities to make
decisions to proceed or stop the project depending on
the outcomes experienced at those stages. The real options
valuation of this project produces a different picture.
First, we handle the market return uncertainty as
follows:
The expected value and its variance of the future
cash flow is:
where E[V 2] is the expected value of the square of the
possible cash flow outcome, and E 2[V] is the square of the
expected future cash flow.
The standard deviation per annum of the under-
lying cash flow is:
T is the time to acquire the future cash flow, here
is 3. v is the above-computed variance.
The present value of the expected uncertain future
cash flow will be, EPV:
The present value of the expected cash inflow and its
standard deviation per annum also can be obtained through
Monte Carlo simulation, sensitivity analysis, or directly, using
market data for share(s) with similar risk characteristics.
The one-year multiplier for up movement and down
FALL 2003
movement of the expected future cash flow is:
Here u and d are the multipliers for up movement and
down movement, respectively, of the EPV in one year. e is
the standard deviation per annum of the EPV. t is the year
number from present for each of the movements. Here t
is 1, which means we examine the possible market return
once per year. (For a detailed review of drift processes and
the multiplier derivation see Dixit and Pindyck [1994].)
Risk-free probability is as follows (refer to Expres-
sion 5 above):
As the information comes in a time-by-time pattern,
we prefer the binomial model to simulate the movement
of the project cash flow. It implies that at the end of every
year, the marketing department re-evaluates the future
cash flow and the engineering department re-evaluates
the technical outcome. The movements of expected pres-
ent value of future cash flow and the technical risks asso-
ciated with project implementation are depicted in Exhibit
7, which provides a full picture of the project decision
process, cost, revenue, and risks.
There is an apparent analogy between the real option
and the financial option. The project cash flow of year
three will be worth pursuing only if it exceeds the cost
outlay in year two. Management will exercise this option
by making the investment outlay of $10,000,000 to acquire
the then certain cash flow only when the cash flow is
higher than the exercise price (cost outlay of $10,000,000),
but will let go the right if the expected cash flow is lower
than the required exercise price, with the loss of initial cost
for technology verification and prototype.
The option value is: C = Max (cashflow – investment,0).
Exhibit 8A depicts the movements in gross EPV
depending on the market conditions. The corresponding
expected gross present value tree is given in Exhibit 8B.
The option values from year three to year zero are
included in Exhibit 9. The option value in year three is
achieved only after the year-two investment outlay is
made. Where the present value falls below the investment
outlay of year two, the option value equals zero. Using
dynamic programming we roll back to every year the
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 67
 EXHIBIT 8A Thus, the active NPV represents the passive NPV
Project Expected Present Value (EPV) plus the value of management intervention, taking deci-
Tree Movements sions that will resolve uncertainties favorably. As seen from
Exhibit 9, ROV0 has a value of 1647.1.
Year 0 Year 1 Year 2 Year 3

EPV EPV*u EPV*u*u EPV*u*u*u

Option premium: C = NPV a – NPV p = 1,024.65
EPV*d EPV*u*d EPV*u*u*d
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EPV*d*d EPV*u*d*d So management intervention in this project will make

it possible to achieve an additional value of $1,024,650
EPV*d*d*d through careful risk management and staged development.
With active management and keeping the flexibility to
abandon the project if the market conditions turn unfa-
vorable, the project becomes attractive and worthy of
EXHIBIT 8B investment. At the same time, the strategy of the project
Estimated Values for EPV as per Above Movements
to reduce the risk also is outlined. The strategy for this
(Gross)
project is to re-evaluate the project in year one: if the cash
Year 0 Year 1 Year 2 Year 3 flow trends down in the first year, there is still a possibility
that it will go up in the second year. However, if the cash
EPV EPV*u EPV*u*u EPV*u*u*u flow goes down again in the second year, just abandon the
project no matter how the project technical issues are
EPV*d EPV*u*d EPV*u*u*d going. In year two, assuming the prototype was technically
successful and customers liked the product, re-evaluate the
EPV*d*d EPV*u*d*d
project before making the cost outlay of building the plant;
EPV*d*d*d if the cash flow outcome is “ud,” but then trends down in
the following year, abandon it also.

option value while counting in the implementation suc- CONCLUSION

cess probabilities. The option value can be computed
The real options approach has opened a new area
using the risk-free discount rate. For example, the option
for project evaluation, optimal strategies, and decision-
value corresponding to the cash flow status “ud” in the
making on risky projects in a chaotic commercial and
year two will be computed as:
tough regulatory environment. The real options approach
is superior to the traditional project valuation methods
such as DCF in that it factors in the uncertainties associ-
ated with the project in an active way. The use of real
options theory combined with decision tree analysis can
provide a sound methodology for proper project appraisal
Since we can achieve the option value in year two
together with determination of project strategy. The real
only with the probability of 0.6, we have to adjust the
options embedded or created during project conceptual-
option value to reflect the technical risks; pt is the tech-
ization and implementation, or even operation, can have
nical success probability corresponding to that phase.
significant impacts on project value, and should be prop-
ROVs are the option values corresponding to their respec-
erly identified and utilized as part of project management
tive status on the option tree.
strategies. Use of the real options evaluation technique
We count in the pure technical failure cost and dis-
requires continuous monitoring of project and market
count that to present, Cp:
conditions, and proactive decision-making, so that the
real options can be exercised when the planned option
conditions emerge. Traditional methods try to avert invest-

68 COMBINING REAL OPTIONS AND DECISION TREE FALL 2003

 EXHIBIT 9
Project Option Value Tree (ROV values)
Year 0 Year 1 Year 2 Year 3
1,647.1 3,590.2 10,815.8 34,356.0
212.6 1,699.0 6,594.7
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0 0
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0 Doloi, H., and A. Jaafari. “Towards a Dynamic Simulation
ment in high-risk and uncertain projects, while real option
factors in uncertainties and keeps options open.
By building a full picture of uncertain project rev-
enue, uncertain implementation success, and available
decisions, the research attempts to evaluate a project prop-
erly with considerations of the uncertain factors in the
light of the information flows and proactive management.
The method combines the advantages of decision tree
mapping and real options valuation technique. It properly
handles the risks associated not only with market return
but also implementation success. At the same time, it
employs a flexible model and can be used easily to deal
with more complex problems.
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