Investment Decision-Making Using Optional Models (2019)

Investment Decision-making Using Optional Models
Modern Finance, Management Innovation

and Economic Growth Set
coordinated by
Faten Ben Bouheni
Volume 2
Investment Decision-making
Using Optional Models
David Heller
First published 2019 in Great Britain and the United States by ISTE Ltd and John Wiley & Sons, Inc.
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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
Chapter 1. Risk and Flexibility Integration in Valuation . . . . . . . . . 1

1.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2. The scope of real options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2.1. The concept of real options . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2.2. Empirical use of real options . . . . . . . . . . . . . . . . . . . . . . . 7
1.2.3. Paradigms in options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3. Valuation of investments by real options . . . . . . . . . . . . . . . . . . 20
1.3.1. Optional valuation of investments in a
discrete-time approach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.3.2. Optional valuation of investments in a
continuous-time approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.4. Option model extensions by incorporating
new parameters (Levyne and Sahut 2008) . . . . . . . . . . . . . . . . . . . . 35
1.4.1. Stochastic volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
1.4.2. Transaction costs and models with jumps . . . . . . . . . . . . . . . 39
1.4.3. Option pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
1.5. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Chapter 2. Optional Modeling of Investment Choices and

Surplus Value Linked to the Option to Invest . . . . . . . . . . . . . . . . 47
2.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.2. Framework of optional interactions and option to
develop an investment project . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.2.1. Real investment opportunity . . . . . . . . . . . . . . . . . . . . . . . 50
vi Investment Decision-making Using Optional Models
2.2.2. Opportunity to postpone decision-making to infinity . . . . . . . . . 52

2.2.3. Development cycle and taking into account
new information within dependent projects and
focusing on research and development . . . . . . . . . . . . . . . . . . . . . 62
2.3. Option to exchange and abandon an investment project . . . . . . . . . 65
2.3.1. Real options within the replacement
cycle and disinvestment alternatives . . . . . . . . . . . . . . . . . . . . . . 66
2.3.2. The value of an investment project
in the natural resources sector . . . . . . . . . . . . . . . . . . . . . . . . . . 69
2.3.3. Valuation of the abandonment option by investors . . . . . . . . . . 85
2.4. Growth option resulting from investment
decisions and acquisition strategies . . . . . . . . . . . . . . . . . . . . . . . . 88
2.4.1. Company profiles justifying growth option value . . . . . . . . . . . 89
2.4.2. Growth option value related to interactions
between financing and investment decisions. . . . . . . . . . . . . . . . . . 90
2.4.3. Acquisition strategies by the real options approach . . . . . . . . . . 98
2.5. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Chapter 3. Data Generation Applied to Strategic and

Operational Option Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
3.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
3.2. Determining the right time to invest . . . . . . . . . . . . . . . . . . . . . 107
3.2.1. Application to the carry option . . . . . . . . . . . . . . . . . . . . . . 108
3.2.2. Application of the Dixit and Pindyck model . . . . . . . . . . . . . . 110
3.3. Flexibility of asset exchange, abandonment
and temporary shutdown of projects . . . . . . . . . . . . . . . . . . . . . . . . 113
3.3.1. Application to the exchange option . . . . . . . . . . . . . . . . . . . 113
3.3.2. Application to the abandonment option . . . . . . . . . . . . . . . . . 115
3.3.3. Application to the temporary shutdown option . . . . . . . . . . . . 116
3.4. Incorporation of development phases . . . . . . . . . . . . . . . . . . . . 121
3.4.1. Implementation of a two-stage investment project . . . . . . . . . . 121
3.4.2. Valuation of a sequential project . . . . . . . . . . . . . . . . . . . . . 122
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Appendix 1. Demonstration of the CRR Formula . . . . . . . . . . . . . 141
Appendix 2. Stochastic Differential Calculus . . . . . . . . . . . . . . . . 147

Contents vii
Appendix 3. Test of the Black and Scholes Formula and

Return on the Log–Normal Distribution . . . . . . . . . . . . . . . . . . . . 155
Appendix 4. Demonstration of the Black and

Scholes Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Introduction
In order to create value, companies must allocate their resources

effectively and evaluate investment alternatives. By focusing a study on
quantitative techniques such as net present value (NPV), capital recovery
time or potential market evolution scenarios, analysts fail to consider
intangible investment-related factors such as future growth opportunities,
management flexibility or strategic value. In fact, the decision to invest or
not based on the NPV criterion, or more generally on the DCF (Discounted
Cash Flows), assumes that the projected cash flows are deterministic. While
these traditional methods incorporate systematic risk using the discount rate,
they do not consider the total risk of changes in cash flows as measured by
their volatility. In practice, random factors lead the company to generate
cash flows other than those originally expected at the time of the investment
decision. Increased competition may lead, for example, to a downward
revision of the price policy in a spirit of competitiveness. In addition, the
increase in costs of raw materials in the industrial process can force the
company to produce only if market conditions are synonymous with
profitability. The possibility of splitting an investment into several sequences
is also conceivable. By relying on this last criterion, the company certainly
relinquishes economies of scale, but has the advantage of interrupting certain
investment phases when market conditions prove to be less sustainable than
those expected. Finally, a business plan considering positive cash flows can,
in fact, depart considerably from the reality, leading the company to abandon
an unprofitable activity. Consequently, the operational flexibility required
for a company in an uncertain context must be associated with any decision-
making process.
x Investment Decision-making Using Optional Models
This notion of risk is essential in the valuation method by the real

options. The term “real” distinguishes this type of options from financial
options of which the underlying is a financial asset. Financial options
are specific contracts traded on organized or over-the-counter markets,
while real options are found in risky, more difficult to identify and more
specific projects with an operational or strategic flexibility. Real options
are of particular interest when alternative investment management
choices are available to executives or when competitive advantages
allow them to wait before investing. Just like a financial option, a real
option is asymmetrical since it grants the holder the right and not
the obligation to exercise it, that is to say, the right to undertake
an investment or abandon it, the opportunity to take advantage of
sustainable changes and to leave behind unfavorable situations. Thus, an
investment opportunity is similar to a call option to the extent that
the company has the right to purchase the equivalent of the underlying –
namely, the assets required for the operation of the project – at a future date
or before a future date (respectively, the equivalent of a European and
American option) – at a certain price.
According to Leshchiy (2015), real options are the junction between

finance and business strategies to the extent that corporate finance is focused
on the valuation of risky assets in order to maximize enterprise value, while
the business strategy focuses on studying market potential and finding
favorable competitive sources. By highlighting the value of flexibility in
investment decisions, both in terms of its operational and financial aspects,
the real options approach models the creation and maximization of value.
Armstrong (2015) argues that when a capacity constraint exists within an
asset acquisition project, the NPV method may be insufficient in terms of the
quality of the valuation and therefore the budgeting, as opposed to real
options which allow us to consider the values of underlying variables, such
as volatility, which impacts the value of the project.
According to Levyne and Sahut (2008), “investment projects are for

the most part real options pools that are rooted in the following three
elements”:
– the irreversibility of an investment means that the investment generates
a non-recoverable cost (sunk cost) and, once started, it is difficult to stop
Introduction xi
it without losing part of the expenses incurred. Its origin may be related to
the specificity of the investment1, the obsolescence of equipment2 and the
legislative or institutional constraints3;
– the risk associated with real options may be endogenous or exogenous
if, for example, there is a fluctuation in demand, a change in interest or
exchange rates, the arrival of a new competitor, a regulatory change, etc. The
company can influence the risk by carrying the investment project or
undertaking an initial investment phase to gather information for the
continuation of the project. In the event that the project generates cash flows
that can be anticipated, the real options approach is of no use;
– flexibility is defined as the opportunity to benefit from favorable
circumstances and to prevent adverse circumstances. This perfectly reflects
the situation of the holder of an option at maturity. Flexibility can be
strategic4 or operation-related5.
Therefore, for a given level of investment irreversibility, the real options

value associated with a project will depend on risk and managerial
flexibility. The more the company executives can favorably change the
course of the investment project and/or the higher the uncertainty, the more
the associated options will be expensive and vice versa. If a project is
inflexible and uncertainty is low, considering a real options approach is
unlikely to be useful.
Low High
Risk
Average value High value
High
Managerial of real options of real options
flexibility Negligible value Low value
Low
of real options of real options
Table I.1. Real options value
1 Specific to the company or industry to which it belongs.

2 The liquidation value of used goods is generally lower than its purchase value.
3 For example, capital restrictions may prohibit foreigners from liquidating their assets in a
market.
4 This will include the carry option and the growth option.
5 For example, it will be a question of choosing between different raw materials according to
their price.
xii Investment Decision-making Using Optional Models
In this context, to what extent can the notions of risk and managerial
flexibility be integrated into the valuation of an investment project? How
does the real options approach make it possible to effectively value an
investment project of a company?
Chapter 1 will be devoted to the development of a theoretical framework

to present the concept of real options. Indeed, it will be interesting to model
this approach by integrating the fundamental parameters, as well as
extensions in order to tend towards a fair value. Chapter 2 will address the
study of financial literature by focusing, on the one hand, on the interactions
of the different categories of options present within the same investment
project and, on the other hand, by developing the conceptual aspects and
academic extensions of the carrying, exchange, abandonment and growth
options and the resulting acquisition strategies. Chapter 3 will be dedicated
to the practical applications as for the different models exposed in the first
two parts.
1
Risk and Flexibility

Integration in Valuation
1.1. Introduction
The investment must be identified as an entry fee that provides access to

future opportunities. Thus, the value of a project is not limited to the present
value of anticipated cash flows, but must capture all the growth opportunities
that will arise in the future. For this, real options offer a long-term vision.
They have the advantage of incorporating future upside and downside cash
flow opportunities through volatility representing the risk and, consequently,
make it possible to incorporate the notion of flexibility into project
management. In fact, depending on the cash flows, the project can, among
other things, be carried, abandoned, strengthened or developed in sequence.
Volatility is the key parameter of options, whether financial or real. Its
usefulness lies in the fact that the value of derivative financial products or
investment projects depends on the possibility of benefiting from favorable
conditions or, otherwise, reducing losses. In practice, real options remain
less used than the NPV criterion for determining the value of a project.
However, Graham and Harvey’s (2001) and Hartmann and Hassan’s (2006)
studies indicate that about a quarter of Chief Financial Officers (CFOs)
surveyed use the real options approach to help them make investment
decisions. Black and Scholes (1973), on the one hand, and Cox, Ross and
Rubinstein (1979) models, on the other hand, form a basis for the valuation
of investment projects by real options. Initially intended to enhance the value
of financial options, these models are particularly relevant to evaluate a
project taking into account a range of opportunities characterizing it.
Investment Decision-making Using Optional Models,

First Edition. David Heller.
© ISTE Ltd 2019. Published by ISTE Ltd and John Wiley & Sons, Inc.
2 Investment Decision-making Using Optional Models
After the realization of a pragmatic analogy as to the different parameters

constituting these paradigmatic models, it is possible to apply the valuation
of projects assimilated to real options. Thus, projects with growth options,
abandonment options, combined options, sequential development options, or
options for expanding or reducing the activity can be the subject of a
dynamic and at least complementary analysis to that of the NPV criterion.
New parameters have been incorporated into the initial models in order to
improve them by making them more precise. Thus, the notion of constant
volatility established by Black and Scholes is questioned by some
researchers who prefer a stochastic volatility with the objective of
anticipating future developments in the price of the underlying. In addition,
transaction costs complement the models by promoting a better definition of
hedging strategies. Models with jumps are expected to consider important
macroeconomic events. Finally, taking into account the payment of a
discrete-time dividend within a continuous-time model would make it
possible to refine the value of the project even better.
1.2. The scope of real options
Unlike financial options, real options focus on valuing “real” assets, i.e.
investment projects. In this context, an analogy between financial and real
options can be seen. In fact, an investment opportunity is similar to a call
option because the company has the right, not the obligation, to invest in an
asset, on a fixed date or during a given period, on a price known in advance.
Thus, the five fundamental parameters that make it possible to evaluate a
financial option can be similar when it comes to valuing an investment
project. Amran and Kulatilaka (1999), who also believe that real options are
an extension of the theory of financial options applied to real assets (non-
financial), manage to distinguish seven categories of options. As a result,
real options offer some flexibility in the management of an investment
project, unlike traditional methods, as decisions can be made throughout
project implementation.
In practice, Graham and Harvey (2001) find that, while the most
commonly-used method of valuing an investment project is based on the
NPV criterion, real options are used by almost a quarter of the CFOs
surveyed. In other words, this method is more in demand than profitability
index or value-at-risk. By refining the conclusions of these two researchers’
Risk and Flexibility Integration in Valuation 3
study, we see that real options particularly convince large industrial

companies, whose debt and growth are moderate and whose management is
the responsibility of shareholders who pay little or no dividend(s). By
focusing on the use of real options in the pharmaceutical industry, Hartmann
and Hassan (2006) reach the same types of conclusions: about 25% of the
pharmaceutical groups surveyed say they use real options.
The valuation models of real options rely on paradigms regarding the

valuation of the option premium initially established for financial options.
Black and Scholes (1973) set out to establish a continuous-time model,
and Cox, Ross and Rubinstein (1979) consider a discrete-time model. A
convergence between these two formulas allowed us to arrive at extensions
such as taking into account the distribution of dividends.
1.2.1. The concept of real options
Real options involve real activities unlike financial options that

exclusively incorporate financial assets. Luehrman (1998) attempts to draw
an analogy between these two categories of options by presenting an
analytical framework aimed at reconciling options theory with valuations of
investment projects. He compares the similarities between the DCF method
and the options approach by stating that an investment opportunity is similar
to a call option, in that the company can, without being forced to, buy the
assets necessary for the operation of a new activity. He also demonstrates
that the value of the option linked to an investment opportunity has the same
characteristics as that present on the financial markets and that,
consequently, it is possible to evaluate an option falling within the
investment process of real assets. The nuance, however, lies in the fact that
investment opportunities only come once. Synthetic options need to be
established with the ability to replicate payments from investment projects.
In this context, there is an analogy between the characteristics of an

investment project and the five parameters used to calculate the price of an
option. In fact, an investment opportunity is similar to a call option to the
extent that the company has the right to purchase the equivalent of the
underlying – namely, the assets required for the operation of the project – at
a future date or before a future date (respectively, the equivalent of a
European and American option) – at a certain price. The term “real”
distinguishes this type of options from financial options of which the
underlying is a financial asset. Financial options are specific contracts traded

on organized or over-the-counter markets, while real options are more
difficult to identify and specify. Just like a financial option, a real option is
asymmetrical since it gives the holder the right and not the obligation to
exercise it, that is to say, the right to undertake an investment or abandon it,
the opportunity to take advantage of favorable developments and to leave
behind unfavorable situations. Thus, by discounting the value of the assets
held, we obtain the value of the underlying. If the investment action
corresponds to the exercise of the option, the amount of the investment will
be the exercise price of the option. The maturity of the option is the period
during which the investment decision can be carried out. The risk-free
interest rate remunerates the time value of money. The volatility of the
underlying asset is the risk attached to the value of future cash flows of the
project. Thus, the analogy is summarized in Table 1.1.
Investment considered
Financial purchase option Variable
in terms of real option
Current value of assets to be purchased
Price of the underlying asset S
for the operation of the project
Investment to make
Exercise price of option E
to realize the project
Period during which the decision can be Time remaining until the maturity
τ
carried of the option
Time value of money Risk-free rate r
Risk measurement Volatility (standard deviation) of
σ
of project assets returns on financial assets
Table 1.1. Analogy between the parameters of the real option

valuing an investment project and the financial option
Amran and Kulatilaka (1999) distinguish seven categories of real options:

– the growth option gives the company the opportunity to expand into
new markets or new activities. In other words, it is the junction between a
current project and future opportunities. It is often essential to make an
initial investment that can lead to new future growth opportunities if the
circumstances are favorable. These are typically investments in a research
and development project. The growth option is therefore similar to a
European call option, of which the underlying asset is the current value of
the cash flows generated by a future project and which depends on an initial
investment. The exercise price corresponds to the additional investment to be
undertaken to continue the project. Maturity is the time remaining until the
project implementation. To proceed with the initial investment, the overall
NPV of the project, i.e. the NPV of the original project, plus the growth
option of the future project, must be positive. Then, at the maturity of the
option, the additional project is realized, that is to say that the option is
exercised, if the state of nature is favorable; in other words, if the current
value of the cash flows is greater than the investment or if the value of the
underlying is higher than the exercise price;
– the carry option provides the flexibility to wait for the right moment to
invest. This is certainly the most used option. In this case, the company can
wait before exercising its call option linked to a land or a valuable resource.
By remaining attentive to changes in the price of the output, the company
will build or exploit a building or a field, respectively. To proceed with a
traditional valuation, it is necessary to agree on an implicit assumption:
either the investor can immediately undertake the project or definitively
renounce it. In other words, he/she cannot wait. However, in this case, if the
carrying of the investment decision deprives him/her of a portion of the
profits, it may allow him/her to observe the evolution of the environment and
choose the most favorable time to invest. The investor then adapts his/her
investment choices according to this evolution, which allows him/her to limit
the consequences of a possible irreversibility of the investment expenditure.
This possibility of carrying provides additional room for maneuver with
respect to the NPV. This additional value is calculated by a call option. If the
investor exercises his/her right to build or exploit, he/she then appropriates
the net present value of the investment project. If he/she decides to carry out
his/her investment decision, he/she implicitly assumes that the lost profit due
to waiting, having considered the possibility of obtaining new information, is
greater than its cost;
– the learning option makes it possible to defer a project or investment in
the expectation of new information affecting the demand, the amount of the
investment or the production costs (customer expectations, regulatory
standards or technological developments);
– the abandonment option finds its interest in the possibility of stopping
the development of an unprofitable activity, which is equivalent to an
insurance policy for the company. The latter may decide to interrupt at
any time a project because it is disappointing. The standard valuation

methods, consisting of calculating the net present value of future flows at
each period and stopping the project as soon as the NPV is negative, ignore,
however, the asymmetry linked to the fact that by continuing the project
today, we preserve the possibility of abandoning it later if the situation does
not improve. The abandonment decision must therefore take into account
this asymmetry present in the method by the real options. In fact, this is a put
option that makes it possible to either receive the resale amount of the
project assets, or cancel the costs related to its maintenance;
– the sequential development option has the advantage of being able to
divide a project into several stages, at the end of which the company may or
may not have the option of continuing the development of the project if the
phase that has just ended is considered a success. In fact, projects requiring
significant investments are carried out at several time intervals depending on
the performance achieved. By deciding to inject (or not) money at the end of
each step, the company continues (or does not continue) the development of
the project. Each step of the latter generates, consequently, an option that is
exercised or not according to the results of the previous step. For example,
before commercializing a new drug, companies in the pharmaceutical
industry follow a process that begins with the research and development
phases. Then, they perform clinical tests and approach; finally, the
authorities to have their approval. In addition, by making sequential
investments, mining and oil companies adopt this type of approach. After
having obtained and analyzed the results of seismic studies and after having
conducted the first drilling estimating the quantity of the resource to be
extracted, they decide or not to continue their exploitation and production;
– the exchange option of inputs or outputs confers the right to have a
choice between different factors of production and finished products, by
definition substitutable between them, forming part of an industrial process.
A company having gas or coal-fired power plants has exchange options to
the extent that either consumable is exploited depending on its production
costs. In addition, farmers have exchange options on their finished products,
because they will choose to grow one commodity over another depending on
the season and also the price trends. Finally, car manufacturers who produce
different models of vehicles from the same assembly line will adjust the
production volume of each of them according to the evolution of demand
and the margins obtained;
– the option of expanding or reducing production favors the variability

of production throughput depending on market conditions that can lead
to the temporary cessation of production after having begun by reducing
activity. Thus, companies operating oil wells save part of their investment
by stopping production, if the gross selling price of this fossil energy is
below its extraction cost.
This classification is taken up by Smit and Trigeorgis (2004), who stress

the importance of the optional approach in choosing to carry out an
investment project because of their contribution to managerial flexibility. In
fact, the options take into account that decision-making can occur throughout
the life of the project to maximize the expected returns while minimizing the
likely losses.
If, theoretically, the innovative concept of real options for estimating the
value of a project proves relevant due to risk and flexibility integration, the
question is whether practitioners concretely use this method, which may
seem difficult to establish.
1.2.2. Empirical use of real options
Graham and Harvey (2001) conducted a survey of 392 CFOs regarding,

among other things, the techniques they use to evaluate an acquisition or a
project to be carried out. The sample of companies having responded to their
questionnaire is heterogeneous. In fact, 26% of them have a turnover of less
than $100 million and 42% have a turnover of more than $1 billion. 44% of
the companies in the sample have a production activity, 15% are financial
companies, 13% are specialized in transport and energy, 11% have a retail
activity, 9% belong to the high-tech sector and 8% are geared towards other
activities. The median PER of the sample is 15. As a result, the authors
consider that companies that meet or exceed this median PER (60% of the
sample) are growing.
In addition, the indebtedness of the sample is fairly uniform insofar as

one-third of companies have a debt to assets ratio below 20%, one-third have
the same ratio of between 20% and 40% and the last third have a debt to
assets ratio of more than 40%.
Graham and Hervey estimate that companies with a ratio above 30% are
in debt. Thus, the tables presented below identify the responses of the CFOs
of the companies in the sample to the question: “How often does your
company use the following techniques when deciding whether to pursue a
project or an acquisition?”
Even though the survey reveals that the most used methods in these
contexts are, by far, the internal rate of return and the NPV, with nearly 75%
of CFOs using them always or almost always, the real options approach is
more solicited than the profitability of assets, value-at-risk or even the
profitability index.
In fact, more than a quarter of the CFOs surveyed say that they always
or almost always rely on this method in the investment decision
support process, at a frequency equivalent to that of the discounted
payback period.
According to this study, the frequency of its application is greater in

large companies with industrial activity, with moderate growth and debt,
managed by executive shareholders and with a low or no dividend
distribution rate.
% always Size PER

and almost Average No
always Small Large Growth
growth
Internal rate of
75.61 3.09 2.87 3.41 3.36 3.36
return
NPV 74.93 3.08 2.83 3.42 3.30 3.27
Payback period 56.74 2.53 2.72 2.25 2.55 2.41
Barrier rate 56.94 2.48 2.13 2.95 2.78 2.87
Sensitivity
51.54 2.31 2.13 2.56 2.35 2.41
analysis
Multiples 38.92 1.89 1.79 2.01 1.97 2.11
Discounted
29.45 1.56 1.58 1.55 1.52 1.67
payback period
Real options 26.59 1.47 1.40 1.57 1.31 1.55

Profitability of
20.29 1.34 1.41 1.25 1.43 1.19
assets
Value-at-risk 13.66 0.95 0.76 1.22 0.84 0.86
Adjusted NPV 10.78 0.85 0.93 0.72 0.97 0.69
Profitability
11.87 0.83 0.88 0.75 0.73 0.81
index
Table 1.2. Inventory of responses from the CFOs in the Graham and Harvey’s (2001)
sample to the question: How often does your company use the following techniques
1
when deciding whether to pursue a project or an acquisition ?
Dividend Executive
Debt Sectors
payment shareholders
Low High Yes No Prod. Other Low High
Internal rate of
2.85 3.36 3.43 2.68 3.19 2.94 3.34 2.85
return
NPV 2.84 3.39 3.35 2.76 3.23 2.82 3.35 2.77
Payback period 2.58 2.46 2.46 2.63 2.68 2.33 2.39 2.70
Barrier rate 2.27 2.63 2.84 2.06 2.60 2.29 2.70 2.12
Sensitivity
2.10 2.56 2.42 2.17 2.35 2.24 2.37 2.18
analysis
Multiples 1.67 2.12 1.88 1.88 1.85 2.00 1.85 2.04
Discounted
1.49 1.64 1.54 1.62 1.61 1.50 1.49 1.76
payback period
Real options 1.50 1.41 1.37 1.52 1.49 1.45 1.40 1.52
Profitability of
1.34 1.32 1.40 1.27 1.36 1.34 1.30 1.44
assets
Value-at-risk 0.78 1.10 1.04 0.82 0.95 0.92 0.95 0.86
1 The CFOs answered the question with a score on a scale of 0 (never) to 4 (always). Score 3
represents “almost always”.
Adjusted NPV 0.87 0.80 0.80 0.91 0.78 0.92 0.79 0.99
Profitability
0.74 0.96 0.81 0.83 0.90 0.76 0.81 0.98
index
Table 1.3. Inventory of responses from the CFOs in the Graham and Harvey’s (2001)
sample to the question: How often does your company use the following techniques
2
when deciding whether to pursue a project or an acquisition ?
The attractive results of this study carried out in the 1990s are not unlike
the passion of some researchers of the same decade such as Coy (1999) who
anticipate a “revolution of real options”. In fact, given their recent existence
– Myers (1977) invented the term “real options” four years after the Black
and Scholes (1973) article – it seems, according to Graham and Harvey’s
(2001) research results, that the new real options approach has some success.
However, not all empirical research goes in the same direction. In 2000,
Bain & Company conducted a study of a sample of 451 companies in which
only 9% of them said they used real options analysis when evaluating a
project. Similarly, 11.4% of the 205 companies in Ryan and Ryan’s (2002)
study sample report that they always, often or sometimes, refer to the real
options technique.
In order to recognize their potential utility, Hartmann and Hassan (2006)

attempted to test the application of real options in a given sector – that of the
pharmaceutical industry – potentially subject to this type of analysis by the
amounts committed to research and development. In fact, the two
researchers insist on the notion of risk and flexibility involved in these
expenses in the field of health. It is a sort of productivity crisis in this sector
contributing to higher R&D costs. Firstly, neurodegenerative diseases and
some cancers remain without effective treatment. Then, many traditional
pharmaceutical groups fail to integrate newly acquired knowledge – such as
genome-related information – into their R&D process. In addition,
competition has increased due to patent expiries of leading drugs and the
emergence of profitable generics. Finally, the authorities are more cautious
in extending their safety requirements taking into account the risks observed
with regard to certain drugs already on the market. Their study focuses on
each step of the R&D process.
2 The CFOs answered the question with a score on a scale of 0 (never) to 4 (always). Score 3
represents “almost always”.
Research Preliminary development Later development

Biological Chemical Preclinical Clinical phases
Recording
validation optimization phase 1–3
Table 1.4. The pharmaceutical process of R&D

according to Hartmann and Hassan (2006)
Internal Value
R&D Real
NPV/DCF ROE rate of Scoring of net Multiples Other
steps options
return assets
Research 59% 6% 18% 47% 0% 6% 6% 6%
Preclinical 76% 12% 24% 24% 12% 4% 0% 4%

Clinical
85% 15% 27% 19% 23% 4% 0% 4%
phase 1
Clinical
100% 19% 22% 11% 26% 7% 0% 7%
phase 2
Clinical
100% 22% 30% 11% 26% 7% 4% 11%
phase 3
Recording 96% 21% 29% 8% 21% 8% 4% 13%
Table 1.5. The inventory of the responses of pharmaceutical

companies to the evaluation methods used in a project
according to Hartmann and Hassan’s study (2006)
Based on a questionnaire submitted in 2004, Hartmann and Hassan

analyze, among other things, the evaluation methods used by about 20
pharmaceutical companies.
According to Table 1.5, 23–26% of pharmaceutical groups use options

when evaluating clinical trials. The fact remains that the most common
method remains that of DCF (up to 100% of the sample uses this method in
the clinical phase).
After addressing the practical use of real options, the question is how
valuations are driven and by what types of models. In fact, risk and
flexibility integration leads us to consider fundamental parameters that it is
essential to relate to each other, as well as the space-time in which they fit.
1.2.3. Paradigms in options
The financial option is a derivative product used to build speculative

strategies, arbitrage and risk hedges in the event of unfavorable
developments – upwards or downwards – in the price of an asset. It is a right
to buy (a call) or sell (a put) a financial asset, which is called an underlying,
on a given date (European option) or for a given period (American option) at
a price known in advance, which is called the exercise price. The price of the
option, which is called the premium, is based on the exercise price E, the
price of which the underlying is the subject S, the risk-free rate3 r, the
maturity or the remaining term to maturity of the option τ and the volatility
of the asset4 σ.
Black and Scholes (1973) and Cox, Ross, and Rubinstein (1979)
have established evaluation methods of the option premium. The
former considered it in a continuous-time approach, while the latter
demonstrated a discrete-time approach. The existence of a convergence
between these two formulas has resulted in extensions such as,
among others, taking into account the distribution of dividends5.
The intrinsic value (VI) and the time value (VT) make up the price of
the underlying:
– the intrinsic value represents the value of the contract at the moment
“t”. VI of a call = max (S - E, 0) and VI of a put = max (E - S, 0);
– the time value corresponds to the surplus of the VI in view of the
time remaining to maturity. As long as a probability of exercising the option
at maturity exists, investors are ready to pay a surplus to hold the option.
This surplus reaches its maximum value when the option is at the money
(S = E)6. At maturity, the time value is zero, which implies that the option
premium is equal to the intrinsic value.
3 Since the purchase of a call requires a lower investment than the purchase of the underlying,
during the contract, the option holder may invest the remaining capital at the risk-free interest
rate (r).
4 The volatility of the underlying (σ) is characterized by the annualized standard deviation of
the price returns of the underlying asset.
5 The distribution of dividends at a discrete or continuous rate reduces the value of the option.
Equivalent to a cash outflow, it encourages the exercise of the option as soon as possible.
6 According to the log-normality of the price of the underlying, the probability that S
decreases or increases with respect to E is the same.
An option is called in the money when its exercise price is lower than the
price of the underlying (for a call) or higher than the price of the underlying
(for a put); out the money in the opposite case and at the money if both prices
are equal.
The value of an option is thus an increasing (call) or decreasing (put)

function of the price of the underlying. The probability of a call being
exercised increases as E is low. Its value is a decreasing function of E. The
probability of exercising a put is all the more important as E is high.
Consequently, the put value is an increasing function of E.
Cox, Ross and Rubinstein (1979) valuation model is based on the

assumption that the value of the underlying asset (shares) follows a
discrete-time multiplicative binomial law7. The stock price may, in each
period, either increase and go to uS at the end of the first period, or decrease
and go to dS8 with the respective probabilities q and 1-q. In other words, the
rate of return of the share in each period is either u-1 with the probability q,
or d-1 with the probability 1-q. If the value of the asset increases (or
decreases), the call premium also increases (or decreases) with the
probability q (or with the probability 1-q).
t=0 t=1 t=0 t=1

uS Cu = max (0, uS-E)
S C
dS Cd = max (0, dS-E)
Table 1.6. Representative tree of the Cox, Ross and

Rubinstein model (for t = 0 and for t = 1)
Based on the composition of a hedging portfolio P consisting of

the purchase of a call of which the premium is C and the sale of H shares,
we have:
C = . p. C + (1 − p)C , where p = q = and r = (1 + r) [1.1]
7 Appendix 1. Demonstration of the CRR formula.

8 “θ” for upward and “d” for downward.
In this case, using a discount rate in continuous time:
C=e . E max(S − E), 0 [1.2]
where St is the value of the underlying asset at maturity.
Suppose that a represents the minimum number of upward movements

that the share will undergo during the next n periods so that the call is in the
money and F(a, n, p) the corresponding binomial distribution function:
C = SF(a, n, p ) − Er F(a, n, p) [1.3]
where F(a, n, p) is the probability that the share will follow at least a upward
movements so that the call is in the money at the maturity date.
If the call is in the money, it will be exercised. In other words, F(a, n, p)

is the probability that the call is exercised at maturity. If n – namely, the
number of periods (or subintervals) between the valuation date and the
expiry date – is very high, the stock price multiplicative binomial law
follows a log–normal distribution and the Cox, Ross and Rubinstein formula
(CRR) converges to that of Black and Scholes:
C = SΦ(d ) − Ee Φ(d ) [1.4]
with:
d + [1.5]
√
d = d − σ√τ [1.6]
Φ(x) = e dt [1.7]
√
F(a,n,p) is replaced by Φ(d2), and Φ(d2) is the probability that the call is
exercised at maturity.
Black and Scholes (1972, 1973) presented a model for evaluating

European options. It is established in continuous time according to
the principle of log–normality of the price of the underlying S9,10. As part of

the valuation of options, S defines a geometric Brownian motion:
dS = μSdt + ρSdz [1.8]
where:
– μ designates the expected return of the share (obtained from CAPM);
– σ its volatility;
– dz = ε dt with ε following a standard normal distribution.
Ito’s lemma makes it possible to obtain an expression of a two-variable

function:
– x which defines an Ito process:
dx = a(x, t)dt + b(x, t)dz [1.9]
– t which represents the time divisible into infinitely many periods dt:
dF(x; t) = + a(x; t) + b (x; t) + dt + b(x; t) dz [1.10]
Noting C(S, t) the premium of the call, we replace in the formula of Ito’s
lemma a(x, t) by μS and b(x, t) by σS. So:
dC(S; t) = + μS + S . σ dt + σS dz [1.11]
The Black and Scholes formula is derived from the constitution of an

arbitrage portfolio (risk-free). However, in [1.11], only the term σS dz has
a random component. Consequently, assuming that the achievements of dz
are identical for the option and for the underlying shares, the portfolio will
be risk-free if the terms in dz offset each other, namely:
– σS from the formula of the variation of the option premium;
– σS.dz from the formula of the variation of the price of the underlying
shares.
9 Appendix 2. Stochastic differential calculus.

10 Appendix 3. Test of the Black and Scholes formula and return on the log-normal
distribution.
It is then necessary to compose the portfolio of a sold option and

purchased shares.
Let P be the value of the created portfolio:
P = −C + .S [1.12]
Since:
dP = −dC + . dS [1.13]
= − + μS + S . σ dt − σS dz + μS. dt + σS. dz [1.14]
Simplifying by µS. and µS , we obtain:
dP = − − S .σ dt [1.15]
This risk-free portfolio returns r, homogeneous with dt. As a result:
− − S .σ dt = −C + . S r. dt [1.16]
Simplifying by dt:
− − S .σ = −C + .S r [1.17]
Finally:
+ r. S + S .σ = r. C [1.18]
The partial differential equation, the resolution of which results in

the risk-neutral universe of Black and Scholes formula11, excludes μ,
which corresponds to investors’ risk aversion. Cox and Rubinstein (1985)
show that when the number of periods between the valuation date and
11 Appendix 4. Demonstration of the Black and Scholes formula.

the maturity date of the option tends to infinity, their formula converges to
that of Black and Scholes. The premium C of the call gives:
C = SΦ(d ) − Ee Φ(d ) [1.19]
( )
ℎ d = and d = d − σ√τ [1.20]
√
where:
– S: spot price of the underlying share;
– E: exercise price of option;
– τ: term to maturity (in years);
– r: risk-free rate;
– r’: continuous risk-free rate, with: r’ = ln(1 + r);
– σ: volatility of the underlying;
– Φ(.) : distribution function of the standard normal distribution.
C = SΦ(d ) − Ee Φ(d ) = e Se Φ(d ) − E. Φ(d ) [1.21]
Since Φ(d2) is the probability that the call is exercised at maturity, EΦ(d2)
is the expected cash outflow at maturity. Since Φ(d1) is also a probability
and since S er’τ is the future value of S at the maturity date, the amount
corresponding to S er’τ Φ(d1) is the expected value of the cash receipt at
maturity, assuming that the call was exercised and the underlying asset (the
shares) is immediately sold on the market. Finally, the premium of a call is
the current value of the net cash flow expected at maturity.
Black (1975) presents an option valuation method by considering the fall

of the price of the underlying shares at the time of the payment of
the dividend. The holder of a call does not benefit from a right to dividends
as long as the option is not exercised. If the underlying distributes a
dividend before the maturity date of the option, it is necessary to substitute
S by S’ = S - De-r’t’, in the Black and Scholes formula, with r’ = ln(1 + r).
Merton (1973) assumes a dividend payment in continuous time

at annualized rate q (if a is the discrete rate of return observed, then
q = ln(1 + a)). Considering a distribution of dividends between the date

t = 0 and t = T, the share price changes from S to S T. eqt. Correlatively,
in the absence of distribution, the price ST is obtained in t = T if the share
price in t = 0 is equal to S. e-qt. This implies integrating the effect of
distribution of dividends into the original Black and Scholes formula and
replacing S by S. e-qt:
C = S. e . Φ(d ) − Ee . Φ(d ) [1.22]
This result of C is obtained after solving a partial differential equation

integrating the continuous payment of dividends at the rate q. The
assumption of the constitution of an arbitrage portfolio in the absence of the
distribution of dividends previously retained resulted in:
− − S σ dt = −C + . S r. dt [1.23]
If a dividend is paid at the continuous rate q, the holder of the arbitrage

portfolio acquires, in addition to the equation on the left of [1.23], the sum
qS.dt per share and per time unit dt, i.e. qS.dt for shares. The risk-free
portfolio reports the risk-free rate r. So:
− − S σ dt + q. S. dt = −C + . S r. dt [1.24]
Simplifying by dt, we have:
− − S σ + q. S = −C + .S r [1.25]
By grouping qS and . S , and then simplifying, we find:
+ (r − q) S+ S σ = Cr [1.26]
In this context, as soon as the real options type is identified, its value is
calculated using a continuous-time valuation model, such as that of Black
and Scholes, or in a discrete-time model, such as that of Cox, Ross and
Rubinstein. However, Levyne and Sahut (2008) insist on caution in adopting
them as “some projects include several options that may be exclusive”.
The authors take as an example the exercise of an abandonment

option resulting in the nullity of the value of this temporary stop option.
They conclude by stating that the value of the options of a project does
not equate to the sum of the options evaluated separately. As for the
decision rules, we will retain the adjusted net present value (ANPV)
criterion, i.e. the increased net present value (of the value of the real options
of the project). Thus, the project is deemed profitable if the ANPV is
positive12. In the case of a carry option, the methodology differs to the
extent that the value of the real options has to be compared to the NPV.
If this is greater than the value of the real options, the project can be
completed immediately.
Suppose a company plans to invest in the installation of offices in

order to develop a new market by offering new services. The proposed
project would take place in two stages. The first phase would require
an investment of €1,176,000 specifically for the construction and layout of
the offices. The NPV resulting from this “first project” is negative, with a
value of - €398,000. If we did not consider the second phase of the project, it
goes without saying that the latter should be abandoned. Thus, the second
step is for the company to hold the possibility of proceeding to a new
investment of €2,600,000, in two years, to offer new services. The growth
option in question can therefore be exercised if this additional investment is
made in two years.
Correspondence with a financial

Inputs Value
option to purchase
S or Current value
Price of the underlying asset €2,580,000
of cash flows
E or Additional investment Exercise price of option €2,600,000
Time remaining until
τ or Time in days 730
the maturity of the option
r or Time value of money Risk-free interest rate 3%
σ or Standard deviation of Volatility (standard deviation) of
35%
cash flow returns* returns on financial assets
*Obtained from similar investment returns in the same sector.
Table 1.7. Valuation of the growth option
12 Even though the NPV is negative.

Applying Black and Scholes (1973) formulas [1.19] and [1.20] for the
call price of a share, the value of this growth option is: €560,000.
Consequently, the ANPV of the project is: - 398 + 560 = €162,000.
Consideration of the growth option leads to the acceptance of the project.

As a risk management tool, investment projects can be valued through
options, assuming that managers are able to react to the risks of their
environment. Consequently, financial and real options may be subject to an
analogy by the method used: an investment project can be considered as a
sequence of decisions over time and the risks are taken into account in the
valuations. However, even though real options are prized by large companies
subject to high volatility in their inputs and/or outputs, the fact remains that
their scope is complicated to implement by the restrictive assumptions of
which they are the object, which can distance the values obtained from
reality. It is finally important that the project asset is correlated with its
underlying.
After explaining the two approaches for valuing an investment project by

real options, I found it interesting to put these models into practice by
applying them to the different categories of options that were listed.
1.3. Valuation of investments by real options
The valuation of an investment project by real options can be performed

either in a discrete-time or continuous-time approach. It is a question here of
succinctly putting into practice these two types of methods in the form of
examples of growth options, abandonment options, linked options,
sequential development options and options for expanding or reducing the
activity.
1.3.1. Optional valuation of investments in a discrete-time

approach
Valuations of investment projects using the discrete-time real

options method are based on the model developed by Cox, Ross
and Rubinstein (1979).
1.3.1.1. Valuation of a growth option

Considering an investment project of which the current cash flow value is
2,200 with an investment of 2,500, the NPV is negative and therefore the
project should be abandoned.
Nevertheless, it presents an opportunity for growth to the extent

that, in three years, if the state of the market allows it, it could be
extended. If necessary, an increase in cash flows of 50% is expected with a
cost of 400.
Using the Cox, Ross and Rubinstein binomial model, we design the cash
flow tree over a chosen number of periods, regardless of the number of years
of life of the option. This allows us to determine the quality of the estimate.
Here, we will take six periods13. The parameters of the binomial model are
those presented in Table 1.8.
S 2,200
T 3
σ 35%
r 3%
No. of periods 6
t (no. of years/no. of periods) 0.5
Adjusted risk-free rate 1.0149
up 1.2808
down 0.7808
Pu 0.4682
Pd 0.5318
Table 1.8. Parameters of the CRR binomial model to value a growth option
13 In order for the binomial model to provide an unbiased estimate, a number of periods close
to 100 should be chosen. The values of this model converge to those of the Black and Scholes
model when the number of periods tends to infinity. A trick is to perform the calculation of
the option for two numbers of periods (e.g. 6 and 7) and to average it to get a price close to
that obtained by Black and Scholes.
In the binomial tree that follows, at each period, the value of cash flows
increases by 1.280 in the favorable case and decreases by 0.780 in the
unfavorable case.
0 1 2 3 4 5 6
0 2,200 2,818 3,609 4,622 5,920 7,583 9,712
1 1,718 2,200 2,818 3,609 4,622 5,920
2 1,341 1,718 2,200 2,818 3,609
3 1,047 1,341 1,718 2,200
4 818 1,047 1,341
5 638 818
6 498
Table 1.9. Binomial tree to value a growth option
For period 1, line 0: 2,200 x 1.280 = 2,818.
For period 1, line 1: 2,200 x 0.780 = 1,718.
To obtain the call value, it is necessary to start with the terminal value at
period 6. The final payment is the maximum between 0 and the revenue
related to the expansion of the project.
For period 6, line 0: Max (0; 9,712 x 50% - 400). This is to multiply the
cash flows from period 6 to the growth rate and subtract the additional cost
to obtain the revenue related to the expansion for line 6. Then, we go up the
tree in the opposite direction towards period 0. In a neutral-risk case, the
value at each node is calculated as the discounted expectation of the two
possible values of the option. Assuming the indexes i and j, respectively, for
columns and rows, we have:
, ,
C, = [1.27]
where is the adjusted risk-free rate.

Thus, for C5.0 (period 5, line 0), we have:
0.4682 × 9,712 + 0.5317 × 5,920

C , =
1.0148
0 1 2 3 4 5 6
0 737 1,037 1,427 1,929 2,572 3,397 4,456
1 493 723 1,026 1,416 1,917 2,560
2 305 476 712 1,015 1,405
3 163 282 465 700
4 62 129 271
5 4 9
6 0
Table 1.10. Value of the growth option obtained

by the discrete-time CRR binomial model
By adding the value of the call option to the NPV, the ANPV obtained is
positive. Considering this possibility of expansion, the initial decision not to
invest can be modified.
Project NPV −300

Call value 737.06
ANPV 437.06
Table 1.11. ANPV of the project taking into account the

value of the discrete-time growth option
1.3.1.2. Valuation of an abandonment option

Considering the same investment project as that developed above, but
assuming that it can be resold at any time for a value of 1,800, the project is
offered flexibility comparable to an American put option. It is then easier to
value cash flows with the option, by obtaining an increased current value
(ICV), than to value the option alone. To proceed with this valuation, two
steps are necessary. Firstly, we must value the option as if it were European
considering that it is exercisable only at maturity. Then, it is necessary to

introduce the possibility of reselling the project at any time to give the put
option its “American” character. Assuming that the put option is European,
the project cash flows and resale value are compared only at the maturity
date (period 6). If this value does not exceed 1,800, the company sells its
project and cash 1,800.
For period 6, line 0: Max (1,800; 9,712) = 9,712.
For period 6, line 6: Max (1,800; 498) = 1,800.
Then, by moving the tree in the opposite direction towards period 0, in a

neutral-risk framework, the value of each node is defined as the discounted
expectation of the two possible values of cash flows (CF). The value of CF5.0
(period 5, line 0) is:
0.4682 × 9,712 + 0.5317 × 5,920

CF , = = 7,583
1.014
ICV 0 1 2 3 4 5 6
0 2,445 2,936 3,644 4,622 5,920 7,583 9,712
1 2,080 2,396 2,884 3,609 4,622 5,920
2 1,861 2,033 2,326 2,818 3,609
3 1,761 1,833 1,958 2,200
4 1,748 1,774 1,800
5 1,774 1,800
6 1,800
Table 1.12. Increased value of the cash flows of the

discrete-time abandonment option (European)
The value of the project can be less than 1,800 at intermediate dates,
while the project can be resold at any time.
By browsing the decision tree, going this time from period 0 to period 6,
the project is sold each time its value is less than 1,800.
We notice that this starts at period 3, line 3. However, it goes without

saying that once the project is sold, it no longer generates cash flows. Its
value becomes zero.
ICV 0 1 2 3 4 5 6
0 2,453 2,938 3,644 4,622 5,920 7,583 9,712
1 2,095 2,400 2,884 3,609 4,622 5,920
2 1,885 2,041 2,326 2,818 3,609
3 1,800 1,847 1,958 2,200
4 0 1,800 1,800
5 0 0
6 0

discrete-time abandonment option (American)
The increased value of cash flows with the put option (ICV) is 2,453. It is
higher than that calculated by considering a European put14. The project
ANPV (American put) is shown in Table 1.14.
Project NPV −300

ICV 2,453.14
ANPV −46.86
Value of the American put 253.14
Table 1.14. Value of the project with the discrete-time

abandonment option (American put)
The ANPV15 is negative even considering the put16 value. The project
cannot be undertaken on the basis of this criterion. Moreover, considering
the project by integrating a European put does not change the situation. The
14 This result is in line with the theoretical principle that the price of an American option is
always greater than or equal to the price of a European option because of the possibility of
exercising it at any moment.
15 ANPV = ICV – Investment.
16 Put value: ANPV – NPV.
difference between the two types of options is small (3.4%). To illustrate

this, Table 1.15 shows the ANPV of the project with a European put.
Project NPV −300

ICV 2,445
ANPV −55
Value of the European put 244.80
Table 1.15. Value of the project with the discrete-time

abandonment option (European put)
1.3.1.3. Valuation of a linked option

It is possible to consider that a company combines different options
within the same project. After being identified, the options of the project in
question must be valued together knowing that certain opportunities are
exclusive to each other. Suppose the company resells its investment project
to the extent that profitability is too low. As a result, the company cannot
subsequently benefit from growth opportunities. Using the assumptions of
the two examples above (those of the growth option and those of the
discrete-time abandonment option), the project has a negative NPV of −300
and confers the possibility for its decision-makers to exercise a growth
option in 3 years (consisting of a 50% cash flow increase for a cost of 400)
and a resale option for 1,800 at any time. The project must be valued in two
stages integrating both options. Firstly, the assumption is made that the put
option is European. At the final date chosen (period 6), we choose the
situation that generates the largest cash flows depending on the situation
where the project is kept as is, where it is extended or where it is resold.
For period 6, line 0: Max (9,712; 9,712 × 1.5 – 400; 1,800) = 14,168.
For period 6, line 6: Max (498; 498 × 1.5 – 400; 1,800) = 1,800.
Then, by moving the tree in the opposite direction towards period 0, in a

neutral-risk framework, the value at each node is defined as the discounted
expectation of the two possible values of the cash flows (CF):
0.4682 × 14,168 + 0.5317 × 8,481

CF . = = 10,980
1.014
ICV 0 1 2 3 4 5 6
0 3,116 3,926 5,051 6,551 8,492 10,980 14,168
1 2,489 3,046 3,871 5,025 6,540 8,481
2 2,069 2,406 2,963 3,833 5,014
3 1,830 1,982 2,281 2,900
4 1,748 1,774 1,800
5 1,774 1,800
6 1,800
Table 1.16. Increased value of the cash flows

of the discrete-time linked option (European)
Since the value of the project can be less than 1,800 at intermediate dates,
we go up the tree from period 0 to period 6, and the project is dropped each
time its value is less than 1,800.
We start at column 4, line 4, and post-sale cash flows are eliminated since
they are not collected.
ICV 0 1 2 3 4 5 6
0 3,123 3,928 5,051 6,551 8,492 10,980 14,168
1 2,502 3,050 3,871 5,025 6,540 8,481
2 2,090 2,413 2,963 3,833 5,014
3 1,864 1,996 2,281 2,900
4 1,800 1,800 1,800
5 0 0
6 0

discrete-time linked option (American)
The ANPV of the project is positive thanks to this linked option.

The impact of the growth opportunity on the total value of the project
is greater than the profit obtained since the possibility of reselling

the project.
Project NPV −300
ICV 3,123.43
ANPV 623.43
Value of both options 923.43
Table 1.18. Value of the project with the discrete-time linked option
The value of the two linked options (923.43) is less than the sum of
the call option corresponding to a growth and sale option corresponding
to an American type abandonment option (737.06 + 253.14 = 990.2),
because the abandonment of the project at intermediate dates limits
the possibilities of benefiting from a trend reversal, that is to say,
growth opportunities.
1.3.2. Optional valuation of investments in a continuous-time

approach
Valuations of investment projects using the discrete-time real

options method are based on the model developed by Black and
Scholes (1973).
1.3.2.1. Valuation of a growth option and an abandonment option and

empirical equivalence between the binomial model and that in
continuous time
Using the same assumptions as the examples presented to value
a discrete-time growth option and an abandonment option, we propose
to find an equivalent call value in the first scenario and put value in
the second scenario17 by applying the Black and Scholes model
(in continuous time).
17 And beyond the ANPV.

For the growth option, the parameters and the value of the
continuous-time call option are those presented in Table 1.19.
Current value of project cash flows 2,200

Current value of cash flows related to expansion S 1,100
Cost of investment E 400
Life of the call (year) 3
Risk-free rate 3%
Volatility (standard deviation of S) 35%
CF increase 50%
d1 2.1203
d2 1.5141
F(d1) 0.9830
F(D2) 0.9350
Call value 739.50
Table 1.19. Value of the growth option obtained by the continuous-time B&S model
As cash flow growth in the third year is 50%, the underlying S

is worth 50% of the initial value of the cash flows of the project
(50% × 2,200 = 1,100). Moreover, volatility can be determined from
the historical variance of similar projects of the company in question,
from the estimation of the distribution of the NPV carried out either since
several simulations of the NPV (by changing the parameters) or from
distributions of model parameters or from the variance of returns of
companies having developed the same type of project. It is important to
emphasize that the call value is similar to that obtained with the CRR
binomial model (in discrete time). In fact, with seven iterations, a value of
737.06 was obtained.
The ANPV becomes positive thanks to the call value which compensates
for the negative NPV of the project. Based on this criterion, the company can
undertake the project.

Investment 2,500
NPV (1) −300
Call value (2) 739.50
ANPV (1 + 2) 439.50
Table 1.20. ANPV of the project taking into account

the value of the continuous-time growth option
For the abandonment option, the parameters and the value of the
continuous-time put option are those presented in Table 1.21.
Current value of the project S 2,200

Receipts in case of abandonment E 1,800
Duration to abandon (year) 3
Risk-free rate 3%
Volatility (standard deviation) 35%
d1 0.7826
d2 0.1764
F(d1) 0.7831
F(d2) 0.5700
F(-d1) 0.2169
F(-d2) 0.4300
Put value 230.13
Table 1.21. Value of the abandonment option

obtained by the continuous-time B&S model
Assuming that the project can be sold for 1,800 at maturity, it implies a
valuation of a European-style put by the Black and Scholes model:
P = Ee Φ(−d2) − S. Φ(−d1)
The difference in value of the put obtained by the binomial model and the
Black and Scholes model varies by approximately 6%. To reduce this gap, the
number of periods in the CRR discrete-time approach should be increased.

Investment 2,500
NPV (1) −300
Put value (2) 230.13
ANPV (1+2) −69.87
Table 1.22. ANPV of the project taking into account

the value of the continuous-time abandonment option
As with the binomial approach, the project should not be undertaken on

the basis of this criterion.
1.3.2.2. Valuation of a sequential development option

The purchase of a patent is an investment in a project, even though it is
not immediately viable. In fact, the patent gives the right to the company to
develop a product and market it. But the company will not exploit it if the
current value of the cash flow expected from the sale of the product does not
exceed the cost of development. And if this never happens, the company will
bury the patent and no additional cost will be incurred. Note E = the product
development cost and S = the current value of the expected cash flows. The
patent gain is max (0, S − E), and the patent can be considered as a call on
future incoming cash flows. δ is the dividend yield or the annual cost of
carrying the project, since each year of delay results in a year of less value
creation of cash flows.
The Merton formula, including the dividend yield, is to replace S by S.e-δτ:
C = S. e . Φ(d ) − Ee Φ(d ) and d = [1.28]

√
Suppose a pharmaceutical company wants to buy a patent to manufacture

and sell a new drug for 10 years. If the drug is produced today, the estimate
of the current value of the incoming cash flow is 800, while the development
cost of the drug for its commercialization is 1,000. The risk-free rate is 2%
and the expected cash flow volatility, based on industry benchmarks, is 40%.
The expected cost of delay is 1/10 = 10%.
Based on the NPV traditional approach, the project is not worthy of interest
since the NPV is - 200. However, due to the volatility of industry earnings
assumed at 40%, incoming cash flows are likely to increase in the future based
on current estimates. Based on the option pricing model, its value is 65.
S 800
q 10%
S.exp(-qt) 294
E 1,000
discrete r 2%
continuous r 1.98%
Volatility 40%
Valuation date 01/04/2015
Maturity date 01/04/2025
Duration (year) 10.01
d1 −0.178
d2 −1.443
F(d1) 0.429
F(d2) 0.074
Call value 65.19
Reimbursement 0
Table 1.23. Value of the pharmaceutical patent after the investment project
1.3.2.3. Valuation of an option of expanding or reducing production

It is possible to consider that the valuation of an oil well as part of its
concession cannot be based on a DCF approach given the high uncertainty
on future cash flows resulting from the high volatility of the oil barrel.
Concession can be valued as a portfolio of options for opening/closing the
well according to its profitability prospects over given periods. For a 10-year
concession, it may be considered to compare at the beginning of each year
the selling price of the barrel at its unit cost. Thus, the concessionaire has 10
options for putting into operation. In the following example, we also assume
the price per barrel at €104, the production costs at €80, the volatility at
80%, the risk-free rate at 3% and the installed capacity of 2 million barrels
per year. Table 1.24 details the calculation of the call options available to the
company in order to value the concession of the oil well:
Rank of the option 0 1 2 3 4 5 6 7 8 9
S0 104 104 104 104 104 104 104 104 104 104
E 80 80 80 80 80 80 80 80 80 80
σ 80% 80% 80% 80% 80% 80% 80% 80% 80% 80%
discrete r 3% 3% 3% 3% 3% 3% 3% 3% 3% 3%
continuous r 3% 3% 3% 3% 3% 3% 3% 3% 3% 3%
valuation date 12/03/2015 12/03/2015 12/03/2015 12/03/2015 12/03/2015 12/03/2015 12/03/2015 12/03/2015 12/03/2015 12/03/2015
maturity date 13/03/2015 13/03/2016 13/03/2017 13/03/2018 13/03/2019 13/03/2020 13/03/2021 13/03/2022 13/03/2023 13/03/2024
τ 0.00 1.01 2.01 3.01 4.01 5.01 6.01 7.01 8.01 9.01
d1 6.29 0.77 0.85 0.95 1.04 1.12 1.20 1.28 1.35 1.42
d2 6.25 −0.04 −0.28 −0.44 −0.56 −0.67 −0.76 −0.84 −0.91 −0.98
F(d1) 1.0000 0.7779 0.8024 0.8281 0.8504 0.8696 0.8859 0.8998 0.9119 0.9223
F(d2) 1.0000 0.4852 0.3888 0.3299 0.2868 0.2527 0.2248 0.2012 0.1810 0.1634
C 24 43 54 62 68 73 77 80 83 86
Sum of option
651
premiums
Installed capacity 2,000,000 barrels/year
Production over
the entire period 20,000,000
(10 years)
Value of the
13,026
concession (€M)
Risk and Flexibility Integration in Valuation
Table 1.24. Example of the valuation of an oil well concession

33
– The first option may be exercised immediately if the spot price S of the
barrel is higher than the unit cost. This first option has no time value, and its
intrinsic value is 104 − 80 = $24.
– The second option may be exercised in one year if the price per barrel
exceeds $80.
– ...
– The tenth option may be exercised in nine years if the price per barrel is
$80.
The value of the concession will be the sum of the value of these options
multiplied by the total installed capacity (20 million barrels).
The simulation presented above can be refined by linking spot prices to

futures prices. Hedging transactions or investment strategies may be carried
out by adjustments resulting from stockpiling or the arbitrage relationships
between the physical market and the futures market. The analysis of these
relationships makes it possible to understand that the level of the carrying18,
on a futures market of commodities, is limited to the storage cost of the
merchandise between the current date and the expiry of the contract. The
level of deferral19 is determined by the price that buyers are ready to agree
on to obtain the merchandise. In the presence of surplus stocks, prices cannot
be offset. If this is the case, it would become profitable and risk-free to sell
stocks in the spot markets and, simultaneously, buy them back in the futures
market20. The multiplication of these arbitrage transactions would lead to a
fall in the spot price, as a result of the massive sales of physical stocks, and
to a rise in the futures price following the purchase of contracts. These
transactions would only cease when the futures price would be higher than
the spot price, by an amount representing the storage cost. The existence of
surplus stocks thus leads to a carrying situation. This logic is correlatively
found in the presence of carrying situations. Reverse cash and carry
transactions are all the more unlikely as the shortage is recognized: operators
have actually no interest in disposing their stocks as long as they anticipate a
further increase in the spot price.
18 Positive difference between the future price and the spot price.
19 Negative difference between the future price and the spot price.
20 Reverse cash and carry transaction.
According to Keynes (1930), the stocks at the origin of the carrying

situations in the futures markets are surplus stocks (redundant stocks)
constituted following an error of appreciation. As soon as they appear,
mechanisms for their elimination are established: the price of merchandise
decreases until the increase in consumption or the decrease in production is
sufficient to absorb them. Storage costs (costs of carrying) differ according
to the commodity considered. They are based on various variables, such as
deterioration and obsolescence costs, storage costs and insurance premiums,
the risk of the monetary value of products, financial expenses and so on. As
long as the storage capacities are not saturated, the costs are stable.
Consequently, so is the level of carrying21.
The storage costs theory, originally set in the context of surplus stocks, does
not, a priori, explain the relationship between the futures price and the spot price
when stocks become scarce. In fact, if the futures price is equal to the spot
price plus positive storage costs, how can it become less than the spot price?
In addition, if the futures price does include the storage cost of the merchandise,
an operator, holding stocks and selling in the futures market his/her merchandise
in a carrying situation, does not have to bear the storage cost.
How then explain that in an offset situation, stocks are held without being
hedged by a forward sale, even though this transaction is expensive? The
concept of convenience yield, introduced by Kaldor (1939), provides an
answer to these different questions. It is developed in the second part of the
literature review.
Black and Scholes (1973) and Cox, Ross and Rubinstein (1979) models
are fundamental and considered as paradigms. However, the fact remains
that the assumptions that constitute them are restrictive and perfectible.
1.4. Option model extensions by incorporating new parameters

(Levyne and Sahut 2008)
Authors have proposed incorporating new parameters into existing

models to provide greater precision and practicality. Thus, while Black and
Scholes retain constant volatility, other authors determine stochastic
21 In the oil market, when onshore storage capacities have reached saturation, oil is stored at
sea. This storage method is much more expensive than the previous one; the level of carrying
can have two levels: the first one is determined by the onshore storage costs, and the second
one by the storage costs at sea.
volatility aimed at anticipating the evolution of future volatilities. The effect

of volatility smile described by Aboura (2006) focuses on changes in implied
volatility based on the position of the exercise price relative to the price of
the underlying. Hull and White’s (1987) discrete-time model predicts the
future volatilities that the underlyings will take. In addition, transaction costs
or, more generally, exogenous phenomena or the payment of dividends can
interact on the value of the project. In fact, Leland (1985) includes the effect
of transaction costs in the volatility of the underlying. Boyle and Vorst
(1992) define a hedging strategy compatible with this type of costs, and
Lapied and Kast (1995) construct a model integrating the possibility of
separating from its position at intermediate dates. Merton (1976) is a model
with jumps in which discontinuities in price trajectories are integrated.
Finally, Roll et al. (1981) incorporate a known discrete dividend into a
continuous-time model.
1.4.1. Stochastic volatility
Black and Scholes assume, in their model, constant volatility. However,

the study conducted by Aboura (2006) leads us to consider that there is an
effect of “volatility smile”. The latter results from the observation of changes
in implied volatility with the exercise price of the options. In fact, in the case
where the option is at the money, the implied volatility is the lowest; in cases
where the option is in the money or out the money, the implied volatility is
the highest. This is presented in the form of a smile. In addition, the smile is
more pronounced in the case of puts, because stakeholders are more
sensitive than for downside risk calls, requiring a higher premium. The
behavior of arbitragers who focus on volatility challenges the reliability of
the Black and Scholes model. They have at their disposal three types of
volatility (including mixed volatility22).
Historical volatility is defined as the variability of past returns on a

financial asset23. In other words, this is the standard deviation of the returns
of the underlying, calculated over a period of time expressed as an
annualized percentage.
22 Mixed volatility results from a combination of historical and implied volatilities developed
later and has no real theoretical base.
23 Since historical volatility is calculated on the basis of fluctuations, it has no forecast
content, unlike implied volatility.
In practice, the number of observation days retained is between 45 and

6024. It is interesting to note that intraday volatility is disregarded, since
the analyst generally relies on closing prices. Moreover, historical volatility
proves intrinsically unstable to the extent that the probability distribution
associated with the price movements of the underlying asset is
non-stationary25.
Implied volatility is defined as the determination of the standard

deviation of the returns of the underlying asset in the resolution of the
valuation model formula knowing the price of the option. In theory,
historical and implied volatilities must be identical, but reality through the
law of supply and demand varies the prices of the premiums of the options.
Implied volatility is therefore calculated from option prices. Its value results
from the equality obtained between the price of the effective option on the
market and the value calculated using an evaluation model such as that of
Black and Scholes. In this case, we rely on the Newton–Raphson algorithm
(Gibson 1993), initially giving a value to the volatility and then seeking by
iterations a refined result minimizing the difference between the observed
price of the option and its price derived from the model in question. The
resulting implied volatility is expected to express the future volatility of the
underlying over the life of the option26. In absolute terms, it conveys
uncertainty about the future foreseen by market operators. High implied
volatility can be interpreted as the result of a price instability that leads
investors to pay more for an option. Conversely, options will be cheaper if
the emerging trend seems distinct. In other words, implied volatility reveals
consensus or divergence on future prices between market participants.
However, De la Bruslerie’s work (1988) goes against this reasoning.
According to the researcher, implied volatility is not a sound estimator of
future price volatility.
Consequently, discrete-time stochastic volatility models focus on

predicting future volatilities of the underlyings. Continuous-time volatility
24 There is a method problem in determining the number of days to consider: the larger the
number of days, the greater the influence of the past. Conversely, if the number of days
retained is small, the sample is not representative.
25 For example, historical volatility obtained from a calm period is not useful for estimating
future volatility within a crisis period.
26 This assumes that market participants determine the price of the option using the same
model.
models are used to evaluate options27. Hull and White (1987) are part of this
dynamic by introducing two independent Wiener (Wy and Wv) processes,
and a volatility following a Cox, Ingersoll and Ross-like dynamic (1978)
oscillating approximately 0:
= μdt + σdW [1.29]
dσ = φσ dt + δσdW [1.30]
where:
– µ: expected return of the security;
– σ: volatility of the security;
– φ: expectation of the variance of the instantaneous returns of the

security;
– δ: volatility of the variance of the instantaneous returns of the security.
Hestion (1993) exposes the process of volatility as a square-root-in-shock

process correlated with the price of the underlying28:
= μdt + V dW [1.31]
dV = κ(θ − V )dt + σ V dW [1.32]
cov dW , dW = ρdt [1.33]
27 Several generations of models have succeeded each other: Geske’s (1979) first-generation
deterministic models and Cox and Ross’s (1976) constant elasticity of variance (CEV)
models emphasize volatility as a function of the price of the option; the second-generation or
stochastic pure volatility models such as that of Hull and White (1987), Stein and Stein (1991)
or Heston (1993) focus on volatility following a fully fledged exogenous process; finally,
third-generation mixed models such as that of Bates (1996), Bakshi et al. (1997) and Duffie
et al. (2000) incorporate jumps and stochastic volatility. The latter have a real theoretical
interest. However, they do not propose an analytical solution, and their complexity limits the
empirical tests.
28 In addition, it proves that the correlation between volatility and the support price is
essential to obtain asymmetry in the distribution of returns.
where:
– µ: expectation of the rate of return of the security;
– κ: speed of return to the average level;
– θ: average long-term level of variance;
– σv: coefficient of variation of the instantaneous variance;
– ρ: correlation coefficient between price and volatility of the security.
1.4.2. Transaction costs and models with jumps
Arbitrage theory and the assumption that financial markets are perfect
govern the valuation of derivative assets using conventional methods.
Frictions such as transaction costs that annihilate or delay perpetual portfolio
adjustments – which are necessary to take into account in hedging risks – are
not part of the assumptions used. In fact, the valuation model of a call with
the Black and Scholes method requires the creation of a risk-free portfolio
consisting of shares and an option on the same shares sold. It is necessary to
continuously readjust the number of shares held in order to manage as best
as possible a neutral delta position, that is to say, to obtain a balance from
the random variations of the option price. The incorporation of transaction
costs makes the continuous portfolio adjustment very expensive. Calculated
on the basis of the spread between the sell and the ask price at which the
shares are traded, they are larger when the hedging errors are small and the
periods are short. Hedging strategies are thus more difficult to conduct, and
the arbitration supposed to be conducted by the agents is even more topical.
In order to resolve this contradiction, Leland (1985) designed an optimal
duplication model of an option, incorporating the effect of transaction costs
into price volatility. After being calculated, this volatility is incorporated into
the Black and Scholes model to determine the value of the option. However,
Leland model remains debatable, in that replication portfolio adjustments are
not endogenous. Even though the readjustments of the portfolio are
continuous, the costs of recomposition are infinite, and therefore the call
value should tend towards that of the underlying. Bensaid et al. (1992)
proved that a strategy of super-replication of an option can be more efficient
than a strict strategy of replication, insofar as there is a compromise between
the precision of a hedging and its cost. The longer the hedging strategy in
terms of time, the higher the transaction costs. This strategy must be stopped
from the moment when the gain in the accuracy of the hedging is neutralized
by the transaction costs incurred. It is then possible to define a domain

within which it is not advantageous to recompose its portfolio. In this
context, Dumas and Luciano (1988) focused on considering that an option
can only be evaluated within an optimal portfolio adjusted in continuous
time by the stochastic optimal control technique. Merton (1989), however,
questioned the conclusions of the two researchers because of the complex
and unworkable nature of the proposed solutions. By defining a hedging
compatible with proportional transaction costs, Boyle and Vorst (1992)
determined a range of bid-ask prices within which an option can be traded
without an arbitrage opportunity. Although they partly solved the problem
described above, there is still a more general difficulty. In fact, Lapied and
Kast (1995) demonstrated a paradox concerning the price rule. To answer
this, they formulated a model that includes the possibility of selling the
position at intermediate dates.
Discrete-time models make it possible to choose the number of

recompositions. The question then is which optimal number to choose in the
sense that the bigger it is, the more the relative ranges are explosive. To
achieve this, it seems possible to empirically choose a number of periods
such that the relative ranges obtained converge to those observed on the
market.
Moreover, Merton (1976) integrates discontinuities in price trajectories

by proposing a modeling by a diffusion with jumps using a geometric
Brownian motion and a Poisson process. In fact, the Gaussian model makes
it possible to obtain formulas to evaluate certain derivative products, but
without incorporating the non-stationarity of the variance of the price returns
nor the sudden variations or peaks in these prices. Empirically, there are
jumps in market dynamics. Jorion (1988), in particular, tried to prove it on
the exchange rate indexes. Levy’s processes establish models summarizing
the presence of jumps, leptokurtic distribution and market incompleteness.
They also include crisis phenomena, stock market crashes, risks of default or
bankruptcy. Jump spreads can also be used to apply models with numerical
resolution algorithms using Monte Carlo simulations to calibrate, for
example, volatility surfaces. Cont and Tankov (2004) managed to
statistically and analytically exploit this type of model.
1.4.3. Option pricing
If there are two main types of models to price an option – continuous-

time on the one hand, from the Black and Scholes model, and discrete-time
on the other hand, based on Cox, Ross and Rubinstein’s work – it is
necessary to consider two major obstacles: to retain the most relevant model
and to choose good inputs to introduce into the model in question. The
choices mainly result from the type of option considered – whether it is an
American or a European option – of the nature of the underlying and its
characteristics.
Options on equity index futures are widespread during portfolio

allocation and more commonly as a hedging instrument. At the exercise date,
the call buyer (respectively, the put seller) is in a long position (respectively,
in a short position) of futures contracts. These do not lead to the delivery of
futures, but to a settlement in cash. The amount cashed or disbursed is the
difference between the value of the spot index and the value of the future on
the index. This type of options for index futures generally corresponds to
options on an asset generating a continuous dividend rate (without
considering whether the underlying pays a continuous or discrete dividend).
In this context, the Black model applied to European options with its
extensions is the most judicious to use to value this type of options.
Share option participants have the choice between American-style

short-term options and European-style long-term options. In addition, a
dividend issue affects the choice of a model to consider. In the case of
European options, the adjusted Black and Scholes model (taking into
account a continuous dividend rate) is the one applied by practitioners. In the
case of American options, professionals focus on two models: a
continuous-time model derived from Roll, Geske and Whaley’s work (1981),
incorporating a known discrete dividend, and the discrete-time CRR model,
which takes into account discrete dividends (the iterative nature of the
calculation is slow, but allows us to check for each intermediate date
between the valuation date and the maturity of the option a possible early
exercise of the option). The value of the underlying S is then:
S−D×e [1.34]
where D is the amount of the dividend paid on the date tD.

Equity index options act like stock options. The index point is assigned a
certain value in national currency. It is assumed that the index follows a
general geometric Brownian motion, while each share composing the index
follows a specific Brownian motion. To value the option, the index is
equivalent to a share S distributing a continuous dividend throughout its life.
The distribution rate q results from the average dividend yield for payments
that occur during the term of the option. For European-style options, their
price is calculated using the Black and Scholes model and taking into
account a continuous dividend. The value of the underlying S is then:
S ×e [1.35]
For American options, the model chosen will be more than that of CRR
extended to the consideration of discrete dividends distributed on each share
making up the index during the life of the option.
Regarding the inputs, it is necessary to take into account the value of the
underlying, as well as the elements likely to modify its value between the
initial date and the date of maturity of the option. Although initially suitable
in some models, dividend assumptions should be considered pending the
confirmation of the exact amount by the companies or tax credits to which
the holding of securities gives entitlement. In addition, implied volatility
reflects financial market expectations by taking into account the magnitude
of future changes in the underlying. The Black and Scholes model assumes
constant volatility while, in reality, the risk to be considered is different,
depending on how the underlying moves. The volatility smile that this
implies can be reproduced by models like GARCH, but it is more calculated
by the investors according to the anticipated risk on the underlying. It is
therefore essential to associate the level of implicit volatility from which
these prices are established if we want to compare the prices present on a
market by market-makers. Finally, the Black and Scholes model assumes
that the interest rate is constant, regardless of the maturity of the option.
However, in practice, the chosen rate is selected on the yield curve
depending on the maturity of the option. To estimate volatility for real
options, there are three methods:
– the cash flow method is based on their variability. It is similar to that of
historical volatility by substituting the prices observed on the market by the
estimated cash flows (CF). The calculations are as follows:
- the returns: = ;
- the logarithm of the returns: Ln Rt;

- the yield spread relative to the average (ERM);
- the ERM squared: deviation²;
- the sum of the ERM squared: the sum of the values of “Deviation²
between the initial date and the maturity date”;
- the number of observations;
- the unbiased average of squared deviations (ME);
- the estimated volatility: ME x (Number of periods)Period/Number of periods in
the year
.
The simplicity of this method has two flaws, namely that negative cash
flows should not be inserted because of the logarithm and a limited number
of values are required:
– the proxy approach is an indirect method to find the “true value” of

volatility. The proxy may concern a project similar to the level of
performance and risk profile already achieved. It is also possible to rely on
changes in the returns of companies that are in the same industry as the
project to be valued through the calculation of their historical volatility.
However, it can be considered that a company is not limited to a project that
listed companies have a certain leverage effect because of their debt, which
amplifies their risk and impacts their stock prices, and that the chosen
calculation period often leads to bias. For example, during a stock market
crisis, the historical volatility of companies (financial risk) is not necessarily
correlated with the volatility of their project;
– the Monte Carlo method is a technique identical to that of the NPV. The
objective differs, however, insofar as it is a question of apprehending the
most probable value for volatility. The method is based on simulations of the
project parameters and then the average and the standard deviation of
volatility, in order to define possible profiles for cash flows. It is difficult to
proceed to interpretations, because only the average value of volatility is
retained. However, the standard deviation can then be used to analyze the
sensitivity of the value of the real option to fluctuations in volatility.
1.5. Conclusion
The valuation of projects by real options is based on the same models as

for financial options. After the parameters analogous to the Cox, Ross
and Rubinstein discrete-time approaches (1979) and/or the Black and
Scholes continuous-time approaches (1973) have been defined, it is therefore
possible to value the seven categories of real options determined by
Amran and Kulatilaka (1999) related to investment projects. However,
the assumptions that constitute these models are perfectible. In fact, the
consideration of stochastic volatility instead of constant volatility, the
integration of transaction costs and the payment of dividends are supposed
to improve the value obtained from the option premium, namely the value of
the project.
In the case of financial options, the underlying asset and the option are
generally quoted, while in the case of real options they are not. The
underlying asset of a financial option is a financial asset, such as shares in
companies, bonds or the foreign exchange value of a currency, while it is a
real asset for real options. They make it possible to highlight the value that is
integrated in the traditional calculations of DCF. They make it possible to
increase the NPV thanks to the time premium recognized by the optional
valuation models. In other words, their advocates believe that a premium
must be paid on DCF estimates. Real options are therefore useful for:
– budgeting for an investment:

- when the investor has a deferred option;
- when the investment provides growth potential;
- when the members of a joint venture have an option to abandon the
project;
– valuation:
- of a patent;
- a concession of oil well, forest, gold mine.
Four years after the article by Black and Scholes (1973), Myers (1977)
argued that growth opportunities can be considered as real options, the value
of which depends on future investment. This suggests that the value of a
company can be broken down by the value of assets in place and the value of
growth options. Copeland and Antikarov (2001) insist that a real option is a
right and not the obligation to make a decision at a known price, equivalent
to the exercise price, for a specified period of time that corresponds to the
life of the option. This decision may concern, for example, the delay of an
investment, the expansion, the reduction or the abandonment of an activity.
Finally, Luenberger (1998) stated that any process of taking control of an
activity can be analyzed as a series of real options. Trigeorgis (1993a) stated
that real options involve discretionary decisions or rights to acquire or
exchange an asset at a predetermined price. In this context, the financial
literature proposes to combine different types of real options related to
investment projects. In addition, it defines the parametric specificities of the
different categories of real options by offering models for each of them and
inspired by the paradigms of the financial options.
2
Optional Modeling of Investment

Choices and Surplus Value
Linked to the Option to Invest
2.1. Introduction
In most cases, a valuation by the real options allows us to include the

value of flexibility. From a practical point of view, the option valuation
model is generally used by applying the Black and Scholes formula (1973),
which corresponds to the solution of a stochastic differential equation.
However, if the company has an option to defer its investment to infinity, the
time premium does not decrease gradually. In other words, = 0 is not
consistent with the Black and Scholes model. In this case, the Dixit and
Pindyck formula (1994) must be considered. In addition, the notion of
flexibility attached to an investment project may justify the combination of
several option categories. Trigeorgis (1993b) shows that the interactions
between different options lead to the conclusion that the added value of an
additional option to other real options, exercisable within an investment
project, is generally less than its isolated value. Under these conditions, the
optional valuation of projects that include significant research and
development expenses leads to the consideration of specificities.
Moreover, the valuation of the optimal moment to exercise a real option

is the real challenge relative to any investment decision. Thus, Mauer and
Ott (1995), who are interested in the abandonment option, just like

Damaraju et al. (2015) who focus on the analysis of investment and

disinvestment decisions within joint ventures and alliances, stress the
reluctance of companies to exercise their options as the information level is
not sufficient. Within the natural resources sector, the investment decision
largely depends on the uncertainties of the production policy. The highly
volatile underlyings, the opening and closing costs of non-negligible
concessions and the presence of convenience yield are all parameters that
Brennan and Schwartz (1985) then Siegel et al. (1985) take into account in
their respective models. They consist of defining an optimal policy regarding
the decision to invest, which can also be influenced by changes in strategic
orientation such as the debt policy and possible diversification of activities.
In this context, the financial literature reveals that the more companies
diversify, the smaller the growth options. In fact, the agency problems and
the prospects for growth in the long term, less important in diversified
companies, alter the value of options linked to future opportunities. For this
reason, Long et al. (2004) explain that companies with growth options have
incentives to delay their decision to invest. In addition, growth options may
arise from interactions between investment and financing decisions. In fact,
according to Childs et al. (2005), depending on the structure of the debt of
the company, agency conflicts would encourage shareholders to adopt
different action plans. To be in line with their optional exercise strategy, the
holders of the capital of the company would have an interest in over-
investing to transfer creditors’ wealth or in underinvesting to avoid the
development of wealth for the benefit of creditors. Finally, growth options
may justify takeover transactions. In fact, beyond the considerations of
power and executive compensation1, acquisition strategies would allow the
buyer to benefit from growth options of the target who would be unable to
find ways to implement them. Thus, Smith and Triantis (1995) evoke the
common development biases of which two companies can benefit thanks to a
double contribution: that of the resources of the initiator of the offer, on the
one hand, and that of the real options of the target, on the other hand.
2.2. Framework of optional interactions and option to develop an

investment project
Trigeorgis (1993) examines the nature of the interactions between
different types of real options – the carry option, the abandonment option,
1 Reasons mentioned in Chapter 1.

Surplus Value Linked to the Option to Invest 49
the contract option, the exchange option and the expansion option – by
considering the notion of flexibility relative to the valuation of an investment
project. He identifies situations in which interactions between options
may be weak or high, negative or positive. These interactions depend in
particular on the nature of the options involved in the study and the exercise
price. He demonstrates that the added value of an additional option (within a
project that already has certain options) is generally lower than its value
taken in isolation. In addition, this phenomenon is accentuated as different
types of options are considered. He concludes that financial analysts’
valuation errors due to the exclusion of optional features in investment
projects may be weak.
Dixit and Pindyck (1994) propose an optional valuation model that can
both determine the right time to invest and help support decision-making in
itself. The maturity date of such a hold option is designed to be deferred
indefinitely. Thus, to invest in a project, the waiting time, which is
continuous, must lead to choosing the optimal moment. The latter is the date
on which the sum of the expected and determinable future discounted cash
flows reaches a critical value. Dixit and Pindyck consider, therefore, that
these cash flows define a geometric Brownian motion. Then, instead of
considering the cash flow of the investment project as a variable, Dixit and
Pindyck (1994) replace it with the price of the manufactured product. In
addition, they assume the existence of production costs and try to obtain the
critical value of a project for which the company can afford to wait or invest
immediately.
Childs et al. (1998) study the interactions between several investment

projects and their values as part of a real option valuation. The choice of the
development policy, which can be seen as a starting phase, depends on the
values of the real options resulting from the chosen strategy. The Grenadier
and Weiss model (1997) focuses on determining the right time to migrate to
another technology. New information on a research and development project
is incorporated into the Lint and Pennings (1998) model with jumps. In this
context, other researchers are developing models specific to industries where
research is paramount.
2.2.1. Real investment opportunity
After considering an investment project requiring a series of expenditures

at specific periods, Trigeorgis (1993) designs the following opportunities
that can be converted into real options:
– postpone project implementation (US call option);
– abandon the project without recovering the expenditures made (US call
option);
– reduce project activity by reducing planned investment expenditure
(European put option);
– expand the scope of the project by incurring an additional investment
expenditure (European call option);
– change project with the possibility to recover a specified value (US put
option).
The presence of options exercisable at a later date relative to other

options increases the value of the underlying asset, as these future options
increase the value of the options that precede them. In other words, the value
of the options prior to the others is a sum of the gross value of the project to
which must be added the value of the future options. However, exercising
one option prior to another may change the value of the project and,
consequently, the value of the options that succeed it. Trigeorgis deduces
that here lies a second-order interaction. In fact, if the first option is a put,
the value of the project will be lower since there is a negative interaction,
and if it is a call, the value of the underlying will be higher given a positive
interaction. The greater the joint probability of exercising two options2, the
greater the degree of change in the value of the option prior to the others
and, beyond that, its degree of interaction.
The probability of exercising a future option is impacted to a greater or

lesser degree by the probability of exercising an option that precedes it. As a
result, real options interact to different degrees because of the probability of
their joint exercise.
2 This depends on the similarity of the linked options.

It is in these terms that the value of an option in the presence of other

options may differ from its value taken in isolation. If the two options are of
the opposite type, such as a put and a call, so that they are perfectly
exercised in opposite circumstances (negative correlation), the probability of
exercising the second option knowing that the exercise of the first has taken
place is very small and, in any case, lower than the marginal probability of
exercising the option if it had been on its own.
The degree of interaction would therefore also be small as well as the

additive value of these two options. Conversely, if both options are of the
same type, such as a pair of put or call, the probability of exercising them
would be higher, as well as the extent of their interaction.
In this context, it would be interesting to study the possibility of

postponing the investment decision, that is to say, to be able to determine the
right moment to launch a project.
Assumed data: V = 100; r = 5%; Var = 25%; T = 15 years; POSTPONEMENT = 2 years

NPV of the project (discounted investment expenditure3 of 114.7): - 14.7
Value of a real option
POSTPONE
Abandon (A) Reduce (RD) Expand (EX) Exchange (EC)
(PS)4
22.1; 36.8 -7.8; 6.9 20.3; 35 24.6; 39.3
26.35; 416
Value of two real options
PS & A PS & RD PS & EX PS & EC A & RD
36.4; 51.1 27.7; 42.4 54.7; 69.4 38.2; 52.9 22.6; 37.3
A & EX A & EC RD & EX RD & EC EX & EC
50.6; 65.3 24.6; 39.3 27.1; 41.8 25.5; 40.2 54.7; 69.4
Value of three real options
PS & A & RD PS & A & EX PS & A & EC PS & RD & EX PS & RD & EC
36.8; 51.5 68.2; 82.9 38.2; 52.9 57.1; 71.8 38.7; 53.4
PS & EX & EC A & RD & EX A & RD & EC A & EX & EC RD & EX & EC
71; 85.7 51.9; 66.6 25.5; 40.2 54.7; 69.4 55.9; 70.6
3 Trigeorgis discounts at the rate of 5% (r) of the assumed investment expenditure: in year 1,
an initial investment expenditure of 10; in year 3, an investment expenditure for works of 90;
and in year 5, an investment expenditure for the construction of new infrastructures of 35.
4 The carry option with a value of 26.3 increases the value of the project by 41 (compared to
the value of the project calculated by the NPV method).
5 Value of the project, including the value of the option or options.
6 Value of one or more options.
Value of four real options

PS & A & RD PS & A & RD PS & A & EX PS & RD & EX A & RD & EX
& EX & EC & EC & EC & EC
69.3; 84 38.7; 53.4 71; 85.7 71.9; 86.6 55.9; 70.6
Value of five real options
PS & A & RD
& EX & EC No interaction between five types of real options
71.9; 86.6
Table 2.1. Interactions between different types of real options
2.2.2. Opportunity to postpone decision-making to infinity
The Dixit and Pindyck model (1994) allows for the postponement of
investment decision-making taking into account future cash flows, the
selling price of the product and production costs.
2.2.2.1. Sensitivity of the value of a hold option to the value of future

cash flows
Dixit and Pindyck assume the value V (positive) of discounted future
cash flows:
dV = α. V. dt + σ. V. dz [2.1]
where:
– α: FCF expected growth rate;
– σ: FCF volatility.
In addition, the amount I of the investment is fixed, regardless of the date

on which it is completed.
Then:
– V*: critical value of future cash flows;
– μ: expected rate of return of the share (excluding dividends), the price
of which is correlated with V. In this context, the return of the project is the
same as that of the share;
– δ: future cash flow rate that would be generated by the project.
The return of the share (μ) can be considered as the sum of the future cash
flow rate (δ) and the rate of appreciation (α):
μ = α + δ or δ = μ − α [2.2]
Suppose F the option premium to invest, no matter when. This US (call)

option on the share price V has an exercise price corresponding to I. If the
call is exercised, the company that holds it pays I and receives the
underlying asset at price market V. In addition, the call is worth, in this case,
V – I or the intrinsic value equal to the NPV. If the call is not exercised, the
premium F – which includes the time premium – is greater than V – I. Then:
F ≥ V – I, where F + I ≥ V [2.3]
Consequently, the call must be retained as long as the full cost of the
project (i.e. the investment and the carry option premium) is higher than the
expected current value of the cash flows. The call can be exercised when
F = V – I. Let V* be the abscissa of this point, which corresponds to the
critical value of future cash flows:
F(V*) = V* – I (necessary condition no. 1: corresponding value)
Figure 2.1. The hold option premium based the current value of future cash flows
As F ≥ V – I, the curve and the line F = V – I are tangent at their point of

contact and the slope is equal to 1. An angle of 45° is formed with the
abscissa axis. As a result:
F’(V*) = 1 (necessary condition no. 2: smooth pasting)

In addition, if V = 0, the current value of the cash flows cannot increase.

Then, the project must be abandoned and the option premium is null:
F(0) = 0 (necessary condition no. 3)
The partial differential equation for a call C, the underlying asset of

which is S, gives:
+ r. S. + σ S . = rC [2.4]
To apply this formula to the carry option of a project, it is necessary to

replace: C with F, S with V and r with r – δ to include the project cash flow
rate that corresponds to the dividends paid and to find that C does not have a
time derivative, since the maturity date can be deferred to infinity. Then:
(r − δ). V. + σ V . = rF [2.5]
σ V . (V) + (r − δ). V. (V) − r. F(V) = 0 [2.6]
The second-order differential equation has the following conditions:
F(V*) = V* – I [2.7]
F’(V*) = 1 [2.8]
F(0) = 0 [2.9]
We thus recognize the form:
F (x) + aF (x) + bF(x) = 0 [2.10]
By replacing F(x) with eλx:
λ .e + α. λ. e + be =0 [2.11]
And, by dividing by eλx:
λ . +α. λ + b = 0 [2.12]
It is thus a second-degree trinomial, the roots of which will be denoted as

and . It is then possible to determine A and B such that:
F(x) = Ae + Be [2.13]
F is a linear combination of two particular solutions of the differential

equation. If the partial differential equation has a solution for a type of ,
the characteristic equation is:
σ V . ( − 1). + (r − δ). V. β. V − r. V = 0 [2.14]
By dividing all the terms by :
. σ β. (β − 1) + (r − δ). β − r = 0 [2.15]
+ − − . . − =0 [2.16]
Then: ∆ = − − + 2 . = 0. [2.17]
Let β1 and β2 be the solutions of the characteristic equation:
√
β = [2.18]
is assumed to be the largest value.
√
β = [2.19]
is assumed to be the smallest value.
Recall:
ax + bx + c = 0 est égal à [2.20]
Then:
β β = < 0, é β > 0 β < 0 [2.21]

It is possible to prove that β1 > 1. In fact, the function:
f(B) = σ β + r − δ − σ .β − r [2.22]
is represented graphically by a parabola, knowing that:
– lim f(β) = + ∞ when β tends to +∞;

– f(0) = –r and f(1) = -δ < 0, δ being a positive number.
Thus, we find Figure 2.2.
Figure 2.2. Curve of f
The graph shows that f(1) is negative if β1 > 1. The necessary conditions
make it possible to solve the general form of the partial differential equation:
F = A. V + B. V [2.23]
As: F(0) = 0, β > 0 β < 0, it is necessary that: B = 0. [2.24]
Then: F = A. V . [2.25]
Moreover, F(V*) = V* – I (corresponding value condition) and

F’(V*) = 1 (smooth pasting condition). Therefore:
A. V ∗ = V∗ − I [2.26]
A. β V ∗ =1 [2.27]
∗
= V ∗ − I ou V ∗ − 1 = −I ou ∶ V ∗ =I [2.28]
V∗ = .I [2.29]
∗
A= ∗ = [2.30]
The Dixit and Pindyck assumptions to implement their model are as

follows:
– r = 4%;
– δ = 4%;
– σ = 20%;
– I = 1.
Thus, β1 = 2, V* = 2I and A = 0.25.
Knowing that the decision to invest is indefinitely deferred and that as V*

= 2I, the investment should be made when the sum of the future cash flows
is at least twice the amount of the initial investment7. Subsequently, Dixit
and Pindyck extend their model by including the price of the manufactured
product.
2.2.2.2. Extension of the Dixit and Pindyck model: consideration of

the price of the manufactured product
In the absence of taxation and assuming the cost of production as zero,
Dixit and Pindyck (1994) consider the profit P exactly corresponding to the
sale of the product. Thus:
dP = α. P. dt + σ. P. dz [2.31]
Note:
– α: profit growth rate;
7 Under the NPV criterion, it would be sufficient for the sum of the future cash flows to be at
least equal to one time the amount of the initial investment.
– µ: profit discount rate (calculated from the Medaf);

– V: value of the project.
Assuming that µ is greater than α:
V= [2.32]
Let δ = µ - α. In other words, δ corresponds to the convenience yield of

the project. This is the benefit of holding the product. Thus:
V= [2.33]
The partial differential equation is as follows:
σ P . ( ) + (r − δ). P. F − rF(P) = 0 [2.34]
With the following conditions:
F(P*) = P*- I [2.35]
F’(P*) = V’(P*) [2.36]
F(0) = 0 [2.37]
Then, Dixit and Pindyck establish:
P∗ = . δI [2.38]
P* is the product price for which the company is indifferent to investing

or waiting. Thus:
∗
V∗ = = .I [2.39]
Then, Dixit and Pindyck include production costs.

2.2.2.3. Extension of the Dixit and Pindyck model: the critical value of
the investment project
Assuming that production costs exist, Dixit and Pindyck (1994) seek to
find the critical value of the project for which the company is indifferent to
investing immediately or waiting.
Recall:
– P: price of the manufactured product;
– V: value of the project.
Note:
– π: instant profit generated by the investment project;
– C: production cost.
Knowing that the company starts production if P is at C: π =

max (0, P − C). [2.40]
After creating an arbitrage portfolio, the differential equation is as

follows:
σ P . + (r − δ). P. V − rV + π = 0 [2.41]
In this context, two situations arise:

– if P < C, π = 0 and:
σ P . + (r − δ). P. V − rV = 0 [2.42]
V = E .P + E .P [2.43]
V is the value of the investment carry option, i.e. the value of an option to
use production capacity when the market will allow the company to make a
profit, knowing that β1 is positive and β2 is negative. Consequently, the
project holds value even though the company is unable to generate profit
instantly. In addition, the probability that the investment becomes profitable
decreases as P tends to 0. In this case, V also tends to 0 and so E . is also
equal to 0; knowing that β2 is negative, it is necessary that E2 is zero. Thus:
V = E .P [2.44]
– if P > C, π = P – C and:
σ P . + (r − δ). P. V − rV + P − C = 0 [2.45]
Knowing that − is a particular solution of the above equation:
V = B .P + B .P + − [2.46]
As a result, in the absence of any possibility of postponement, the value

of the project is equal to:
V= − [2.47]
In other words, it is a solution similar to that of the NPV. It results from

the difference between the sum of future revenues discounted at cost of
equity and a perpetual annuity of discounted operating expenses at the
risk-free rate.
Since P tends to infinity, the hold option would no longer exist. Thus, its
value would tend to 0. In other words:
V = B .P + B .P =0 [2.48]
with tending to 0; β1 to be equal to 0. Thus:
V = B .P + − [2.49]
If P is equal to C, the company would be indifferent to waiting or

investing. In that case:
V = E .C = B .C + − [2.50]
Since F (V) has an identical slope, it does not matter that P is less than or
greater than C (at the point P = C, we then see the same derivative):
β .E .C = β .B .C + − [2.51]
Solving the system of equations [2.50] and [2.51], we have:
E = − [2.52]
B = − [2.53]
The option to invest F is as follows:
F(P) = A . P + A .P [2.54]
Since F(0) = 0 and A2 = 0:
F(P) = A . P [2.55]
Considering the investment I to be made according to the contingencies,

the selling price P* reflecting indifference as to whether to invest or to wait
verifies:
∗
A . P∗ = B . P∗ + − −I [2.56]
By deriving F at the critical point P*, we have:
β . A P∗ = β B . P∗ + [2.57]
After having multiplied equation [2.56] by β1 and equation [2.57] by P*,

we have the system:
∗
β . A P∗ = β . B P∗ + − − Iβ
∗ [2.58]
β . A P∗ = β B . P∗ + 4
By subtracting the second equation from the first, a single equation is

obtained with only an unknown P*. This can be found using a numerical
calculation:
∗
β (β − β )P ∗ + (β − 1) −β −I =0 [2.59]
Targiel (2015) insists on the importance of considering the real options

approach in sustainable development projects where the question of
temporality with regard to investment decision-making is paramount. In fact,
by taking an overview of the options that can be considered as the carry
option, the abandonment option or the compound options, Targiel asserts
that the multi-criteria valuation makes it possible to decide when to start the
project as such or approach the next phase. In addition, Franklin (2015)
applies the Dixit and Pindyck model (1994) to investment decisions in the
mobile telecommunications network sector. The investment project is
defined as the purchase, installation and launching of a network where each
element provides a hypothetical network service. These services are
combined by a number of elements and are subject to different demand and
uncertainty, so that an optional value is calculated for each element of the
main network. This range of real options is calculated to favor investment
decision-making. The impact of the hold option disappears as end-point
investments are completed. As a result, the model would enable mobile
operators to make better investment decisions, considering not only its cost
but also the value of the integrated real option. In addition, the model is
intended to help regulators to better assess the costs of mobile services. In
fact, these costs often determine tariff rules. It is understandable then that
real options can easily be a relevant tool for the valuation of specific projects
focused on research and development.
2.2.3. Development cycle and taking into account new

information within dependent projects and focusing on research
and development
According to Childs et al. (1998), project development can occur in

parallel or in sequence. In other words, during the development phase, the
company learns information about the state of the market, as well as about
the interaction that can exist between several projects. Beyond the choice of
the development of a single project, the investment decision can be
motivated by comparing two possible solutions or a sequential development.
Real options are combined to the extent that it is based on the success of a
first investment that the company will choose to make a second investment.
Childs, Ott and Triantis show, therefore, that when projects are highly
correlated, are feasible over a short period of time, require significant
fundraising and have low volatility, sequential development turns out to be a
better choice than parallel project development. Conversely, parallel project
development is of greater interest when development costs are low because

of high uncertainty, because it generates large cash flows and because it
requires long periods of putting them in practice.
Childs et al. (1998) rely on two examples from the aeronautics sector to
justify their remarks. Based on McDonnell Douglas’ company project
development, the authors envision investing in a cargo aircraft designed
from a passenger aircraft model. Unlike airplanes carrying passengers,
aircraft carrying goods must not have windows. A first possibility would be
to modify the body of the device. The second possibility would be to replace
the windows of the original aircraft. The investment expenditure of the first
case is higher than the second because it is necessary to carry out a study
phase for the design. McDonnell Douglas chose to develop both projects in
parallel because the correlation between them is close to zero. The second
application case deals with the manufacture of a new aircraft model. It is
then recommended to proceed with a sequential development of several
prototypes because the information revealed by a prototype can be used for
the design of another one.
Grenadier and Weiss (1997) develop a model to determine the right time
to migrate to a new technology. It is, in fact, an option to invest for a
company according to several possibilities:
– either the company invests in the current technology at an exercise
price Ce from the beginning of the project (i.e. t = 0)) and, in t = T, it has the
possibility to keep its technology or to invest in a new technology by
spending the amount Cu;
– either the company does not invest in t = 0, but in t = T, it has the
choice to opt for the current technology at the price of Cd or for the new
technology at the price of C1. In this case, the authors assume that
investment in current technology is less expensive in t = T than in t = 0. In
addition, the expense C1 realized in t = T is less than the sum of the amounts
invested by the company adopting the current technology project in t = 0 and
the new technology in t = T.
After an empirical study on business behavior, the two researchers

observe that, as uncertainties about technological change are significant,
companies are moving towards direct investment in new technologies or
prefer to wait for the arrival of an innovation to invest in the previous one.
Lint and Pennings (1998) integrate the knowledge of new information

from a research and development project into a discrete Poisson process,
leading to no longer considering the value of the option in continuous time,
but according to a model with jumps. Thus, decision-making can be delayed
because the information that reaches the company includes the appearance,
within the sector, of new technologies that can lead to a reduction of
production costs and the arrival of new competitors. In this context, the
variance of the underlying project is as follows:
σ = λ. γ [2.60]
with:
– λ: number of jumps planned per year;

– γ: anticipated variation of the value of the project at each jump.
We then have the value of the following investment option c(t):
c(t) = S(t)N d + σ λ. γ. τ − I. e N(d) [2.61]
with:
( ) .

d= [2.62]
. .
where:
– S(t): value of the project;

– I: amount of the investment;
– r: risk-free rate;
– τ: remaining maturity of the project.
In addition, Wesseh and Lin (2015) evaluate the viability of wind energy
projects in China through the real options approach. The latter allows them
to take into account the flexibility offered by the deployment of this
technology in response to a stochastic cost of non-renewable energies.
According to the authors, the difference between this cost and research and
development expenses for this type of more ecological project is to take
advantage of the wind. On the other hand, the Chinese government

subsidizes this industry to encourage its development. The work of the two
authors therefore shows that wind energy is an economically attractive
activity, because there is a substantial optional value in the Chinese program
in full development – a value that is all the greater if the cost of carbon
dioxide emission is internalized.
Based on the real options approach, Lund and Jensen (2016) question the
profitability of an activity related to the development and commercialization
of an animal vaccine. They find that the project value of this type of
investment, which requires the integration of several phases, is more
important when real options are integrated. In other words, when the various
steps required to commercialize a vaccine (i.e. research, design, testing,
approval, and launch) are designed as abandonment options using a binomial
approach because of their flexibility – the completion of a step depends on
the success of the one that precedes it – the real options framework can
improve the financial analysis of investment decisions. In particular,
according to the authors, the real options approach is more relevant for
assessing vaccine development costs. In addition, they consider that the use
of real options offers a more nuanced assessment in taking into account
alternative policies by encouraging the abandonment of projects with poor
prospects or by giving the possibility of reselling projects at intermediate
stages. Finally, based on the Dixit and Pindyck model (1994), Baldenius
et al. (2016) develop a dynamic congruence model in which information
arrives over time, allowing the manager to anticipate, relative to the
shareholder, investment and operating decisions. The authors then show that
if demand follows a stochastic process, the expected optimized profits slow
down. This decline does not occur in the event that the company is unable to
adjust the use of its capacity. This is justified by the fact that the value of the
carry option decreases if the company is affected by a series of adverse
demand shocks impacting the profit level. Thus, valuation models of
investment projects in the presence of abandonment or exchange options
have been developed.
2.3. Option to exchange and abandon an investment project
Magrabe (1978) designs an asset exchange option valuation model. The

value of the project then corresponds to the value of a European call option.
By looking at the optimal time to renew an asset, Mauer and Ott (1995) find
that, on the one hand, the volatility of operating costs as well as the purchase
price of the replacement asset and the corporate tax rate increase and, on the
other hand, companies are waiting to gather as much information as possible
before making all types of decisions, which lengthens the renewal cycle. The
uncertainty of decisions to invest in joint ventures or alliances encourages
Damaraju et al. (2015) to integrate the presence of options in the choices of
corporate governance modes. For example, divestment is similar to
exercising the sale of a put option. Here again, companies are encouraged to
wait until they have enough information before deciding on a possible
abandonment.
In the natural resources sector, production is subject to uncertainty. The

integration of real-option-based models, such as that of Brennan and
Schwartz (1985), makes it possible to define policies that optimize the
decision to invest by retaining the effects of time, costs, and convenience
yield, i.e. the profit a producer derives from his/her stocks. Siegel et al.
(1985) integrate volatility in their valuation model of an operation of an oil
well concession. In order to explain the parameters influencing the
optimality of the investment decision, they make an analogy with stock
options.
The evolution of the strategic orientation, considered as a policy of debt

reduction or refocusing activity, can also justify the exercise of abandonment
options. Clark et al. (2010) even inquire as to whether investors value
abandonment options when they separate from their securities, especially in
a context of non-efficient markets (if not, as information is public, valuation
cannot be biased). They observe that abandonment options are undervalued
by about 1% due to early exercise.
2.3.1. Real options within the replacement cycle and

disinvestment alternatives
Drawing on the Black and Scholes model, Magrabe (1978) suggests an

exchange option valuation model in which a company can replace an asset
with X2 as a random price with another asset with X1 as a random price. In
this context, the value of the investment project w(X1, X2, t), which
corresponds to the value of a European call option exercisable at the date t*,
is as follows:
w(X , X , t) = Max(0, X − X ) [2.63]
The exercise price is thus equated with the value of the asset X2 in order
to acquire the asset X1. The value of X1 expressible in unit of asset 2
corresponds to the ratio of X1 on X2 knowing that asset 2 is equal to 1 unit
(ratio of X1 on X2). The volatility of the underlying w is as follows:
σ = σ +σ − 2cov σ ;σ [2.64]
σ = σ +σ − 2ρ. σ .σ [2.65]
Assuming that the linear correlation coefficient ρ is equal to:

( , )
ρ= [2.66]
.
so: cov(X , X ) = ρσX . σX . [2.67]
By reasoning from a market equilibrium situation, Magrabe assumes a

zero risk-free rate. In this context:
w(X , X , t) = X ϕ(d ) − X ϕ(d ) [2.68]
where:
.
.
d = [2.69]
√
d = d − σ √τ [2.70]
with:
– τ: remaining maturity of the option;

– Φ: distribution function of the standard normal distribution.
On the other hand, if the assets X1 and X2 are dividend-yielding shares, at

the respective rates q1 and q2, the value of the exchange option C must be
taken into account in the Black and Scholes formula the distribution rate and
the compensation differential of the shares concerned. We then have:
C=X e Φ(d ) − e Φ(d ) [2.71]
where the risk-free rate r is assumed to be zero and:

.
d = [2.72]
√
d = d − σ √τ [2.73]
The Mauer and Ott (1995) asset renewal cycle concludes that the optimal
time to replace it increases the volatility of operating costs, the purchase
price of new assets and the corporate tax rate. However, they note that this
right time is consistent with a reduction in the systematic risk of costs, the
salvage value of the asset and the tax credit related to the investment. The
optimal cycle can also evolve based on the depreciation rate. Finally, the
appearance and adoption of a new technology reduces operating costs.
However, in response to the work of Childs et al. (1998) and Grenadier and
Weiss (1997), Mauer and Ott observe that companies choose to wait before
investing in new technologies to give themselves time to gather additional
information to limit uncertainties. The renewal cycle is thus extended.
Damaraju et al. (2015) examine the decision to divest from companies in

joint ventures or alliances through the real options approach as these shares
are sensitive to uncertainty. As a result, choices in governance modes must
incorporate the presence of optional values. In fact, the ownership of a
business unit has a conceptual analogy with the holding of a put option.
Thus, disinvestment corresponds to the exercise of the sale of this put option.
Moreover, in an uncertain environment, the real value of a business unit
cannot be precisely appreciated. In other words, its current value cannot be a
good indicator of its future value. Under such conditions, by divesting, i.e.
by exercising its put options, the company could incur significant losses that
prevent it from taking advantage of new opportunities.
It is in these terms that, in accordance with Dixit and Pindyck’s findings

(1995), it may be more appropriate, in the face of great uncertainty about the
market, to wait rather than deciding too quickly to divest. Based, in
particular, on a sample of 230 divestitures and 153 splits between 1980 and
2003, Damaraju, Barney and Makhija empirically conclude on the accuracy
of this prediction: when the uncertainty in the environment of company
business units is high, the latter are reluctant to sell their shares, preferring to
preserve their options for disinvestment. Given the significant uncertainty
that dominates the natural resources sector, researchers have focused on the
value of investment projects relating to commodities.
2.3.2. The value of an investment project in the natural resources

sector
Price variability does not affect the valuation of certain projects in which
the underlying is relatively predictable, but it is of extreme importance in the
natural resources sector where securities vary between 25 and 40% per year8.
The Brennan and Schwartz model (1985) focuses on defining an arbitrage
portfolio, the cash flows of which replicate those to be valued (Harrison and
Kreps 1979). The construction of such a portfolio assumes that the
convenience yield of the return of the commodities is expressed as a function
of the spot9 of the latter and that the interest rate is non-stochastic. These
assumptions lead to a relationship between the spot price and the future price
of the resource. Thus, project cash flows are adjusted by an arbitrage
portfolio consisting of risk-free assets and future contracts. The first step in
analyzing an investment project is to determine the current value of its future
cash flows. It will then be necessary to compare it with that of the required
investment in order to know whether to invest immediately or wait.
2.3.2.1. Farm valuation and optimal production policy

Convenience yield, according to Kaldor (1939), is defined as the profit
that a producer withdraws from his/her stocks, without bearing the cost
associated with frequent orders or waiting for deliveries. This comfort,
linked to the availability of stocks, justifies that the spot price may become
higher than the futures price. When the market is in short supply,
8 Bodie and Rosansky (1980) estimated, over the period 1950–1976, the standard deviation of
annual price variations of about 25% for silver, 47% for copper and 25% for platinum.
9 Spot means “price of the underlying” or “spot price”.
convenience yield can become higher than the storage cost, and an offset
situation can be established. Brennan (1958) points out that the uncertainty
of future demand is an incentive to hold stocks in a deportation situation.
The model studied retains the spot price as sole explanatory variable of the
futures price considering a constant convenience yield. A project using a
single natural resource is assumed. The spot price, S, of the latter follows a
geometric Brownian motion:
= μ dt + σdz [2.74]
with
– dz: increment of the Brownian motion associated with S = ε dt and ε →

N(0, 1);
– σ: volatility of S;
– µ: anticipated instantaneous return of S.
Before developing the model, it is necessary to study the relation between

the spot, its future evolution and the convenience yield of the commodity.
Convenience yield is “the flow of services that increases the value of the
stock of the physical resource holder” (Working 1948; Telser 1958). It is
held by those for whom the net marginal rate is high. The latter evolves in a
proportionally inverse way to the amount of the stored resource and the spot.
Thus, the net marginal rate of convenience yield is a function of the price of
the underlying at time t. It is noted C (S, t).
However, convenience yield as such is proportional to the spot of the

resource. Suppose a constant interest rate ρ relating the spot to its future
prices. F (S, τ) represents the future price, at time t, of the delivery of a unit
of the resource at time T (τ = T – t). By Ito’s lemma10, the instantaneous
evolution of future prices is:
dF = −F + F σ S dt + F dS [2.75]
Consider the instantaneous return of a portfolio consisting of the purchase

of a resource unit and the sale of (Fs)-1 in the futures market. Using [2.75],
10 The concept of Ito’s lemma is explained in Appendix 2.

the instantaneous return that includes a net marginal rate of convenience

yield is:
( )
+ − (SF ) dF = (SF ) F C(S) − F σ S + F dt [2.76]
Let C (S) be the convenience yield (net) of a marginal unit of stock. If the
instantaneous return is non-stochastic, then it must be equal to the risk-free
rate ρ dt. We obtain the following differential equation:
F σ S + F (ρS − C) − F = 0 [2.77]
Future prices represent the solution of [2.77]:
F(S, 0) = S [2.78]
Future prices are based on spot and time to maturity. The parameters of
the convenience yield function can be estimated directly by the relationship
between the spot and the future prices. If the convenience yield is
proportional to the spot:
C(S, t) = cS [2.79]
Using equations [2.75], [2.77] and [2.78], the instantaneous variation of

the future price of the resource is expressed using convenience yield:
dF = F [S(μ − ρ) + C]dt + F Sσ dz [2.80]
The operation value depends on the production rate q, the spot S, the
stocks of the concession Q, the time t and the operating policy φ.
Mathematically:
H ≡ H(S, Q, t ; j, Φ) [2.81]
The variable j is equal to 1 if the operation is open and 0 if it is closed. In

the first case, the operating policy is expressed by the production rate
function q(S, Q, t) and:
– S1(Q, t): price of the underlying at the moment the operation is stopped
or abandoned;
– S2(Q, t): price of the underlying at the time of the resumption of

operations while it was stopped or abandoned;
– S0(Q, t): price of the underlying at the time of the abandonment of the
operation while it was stopped.
Applying Ito’s lemma to [2.80], the variation in the value of the operation
is:
dH = H dS + H dQ + H dt + H (dS)² [2.82]
where:
dQ = −q dt [2.83]
Cash flows (of the operation) after tax are:
q(S − A) − M(1 − j) − λ H − T [2.84]
where:
– A(q, Q, t): production flow cost rate;

– M(t): after-tax fixed maintenance cost rate of the operation at time t
while it is closed;
– λj(j = 0, 1): proportional rate of taxes on the value of the operation,
whether open or closed;
– T(q, Q, S, t): corporate tax when the farm is operated.
In order to derive [2.81], let us consider the return of a portfolio

consisting of the purchase of a concession and the sale of future contracts.
The return of the operation is [2.82]–[2.83] and the future price variation is
[2.80]. Combining with [2.74], the return of the portfolio:
σ S H − qH + H + q(S − A) − M(1 − j) − T − λ H +
(ρS − C)H [2.85]
If the return is non-stochastic, then it must be equal to the risk-free rate,

ρH, of the value of the investment. Using expression [2.85], the value of the
operation must satisfy the following differential equation:
σ S H + (ρS − C)H − qH + H + q(S − A) − M(1 − j) − T −

ρ + λ H = 0 [2.86]
The value of the property satisfies [2.86] for each operating policy
ϕ = {q, S0, S1, S2}.
When the latter is maximized ϕ* = {q*, S0*, S1*, S2*}, the values of the
operation when it is open, V(S, Q, t), and when it is closed, W(S, Q, t), are:
V(S, Q, t) ≡ max H(S, Q, t ; 1, Φ) [2.87]
W(S, Q, t) ≡ max H(S, Q, t ; 0, Φ) [2.88]
In addition, the value maximizing production and the value of the

operation satisfy two equations (Merton 1971; Fleming and Rishel 1975;
Cox et al. 1978):
max ∈ ,
[ σ S V + (ρS − C)V − qV + V + q(S − A) − T −
( ρ + λ )V] = 0 [2.89]
σ S W + (ρS − C)W + W − M − ( ρ + λ )W = 0 [2.90]
If the opening, closing and abandonment policies are known to investors,

we have:
W(S ∗ , Q, t) = 0 [2.91]
V(S ∗ , Q, t) = max [W(S ∗ , Q, t) − K (Q, t), 0] [2.92]
W(S ∗ , Q, t) = V(S ∗ , Q, t) − K (Q, t) [2.93]
where K1(.) and K2(.) are, respectively, the costs of closing and opening the
operation.
Finally, according to Merton (1973) and Samuelson (1965):
W (S ∗ , Q, t) = 0 [2.94]
W (S ∗ , Q, t)si W(S ∗ , Q, t) − K (Q, t) ≥ 0

V (S ∗ , Q, t) = [2.95]
0 si W(S ∗ , Q, t) − K (Q, t) < 0
W (S ∗ , Q, t) = V (S ∗ , Q, t) [2.96]
The value of the operation depends only on time because the costs A, M,
K1 and K2 and convenience yield C depend on it themselves. If the inflation
rate π is constant for each of these parameters and if C (S, t) can be written
κS, then [2.89]–[2.96] can be simplified. Let us define:
a(q, Q) = A(q, Q, t)e [2.97]
f = M(t)e [2.98]
k (Q) = K (Q, t)e , k (Q) = K (Q, t)e [2.99]
s = Se [2.100]
v(s, Q) = V(S, Q, t)e [2.101]
w(s, Q) = W(S, Q, t)e [2.102]
Then, the deflated value of the concession satisfies:
max ∈ ,
[ σ s v + (r − ĸ)sv − qv + q(s − a) − τ −
( r + λ )v] = 0 [2.103]
σ S w + (r − ĸ)sw − f − ( r + λ )w = 0 [2.104]
where:
r = ρ − π is the real interest rate [2.105]
τ = t qs + max t q[s(1 − t ) − a], 0 [2.106]
w(s ∗ , Q) = 0 [2.107]
v(s ∗ , Q) = max[w(s ∗ , Q) − k (Q), 0] [2.108]
w(s ∗ , Q) = v(s ∗ , Q) − k (Q) [2.109]
w(s, 0) = v(s, 0) = 0 [2.110]
w (s ∗ , Q) = 0 [2.111]
w (s ∗ , Q) si w(s ∗ , Q) − k (Q, t) ≥ 0
v (s ∗ , Q) = [2.112]
0 si w(s ∗ , Q) − k (Q, t) < 0
w (s ∗ , Q) = v (s ∗ , Q) [2.113]
Equations [2.103]–[2.113] constitute the general model of the value of an

operation, but there is no analytical solution, although it is conceivable to
solve it numerically.
Brennan and Schwartz (1985) then present a simplified model. To do this,

the stocks of the resource, Q, are assumed to be infinite, the purpose being to
simplify the equations [2.103] and [2.113] of the value of the operation. It is
assumed that there are only two exploitation rates: q* when the operation is
open, and 0 when it is closed. Costs are incurred to move from one to the
other. Thus, the deflated value of the concession when it is opened and
operated at the rate q* satisfies the differential equation:
σ s v + (r − ĸ)sv + ms − n − ( r + λ)v = 0 [2.114]
where: m = q*(1 – t1)(1 – t2) and n = q*a(1 – t2).
Assuming that f (maintenance cost for a closed operation) is zero, the

deflated value of the closed concession satisfies the differential equation:
σ s w + (r − ĸ)sw − (r + λ)w = 0 [2.115]
The solutions of equations [2.114] and [2.115] are:
w(s) = β s +β s [2.116]
v(s) = β s +β s + − [2.117]
ĸ
where the β are constants and:
γ = α + α , γ = α − α [2.118]
ĸ ( )
α = − , α = [α + ] [2.119]
²
If (r + λ) > 011, then β2 = 0 since γ2 is negative and w(s) is finite (s tends

to zero). And, if γ1 > 1, then β3 = 0. The value of the closed concession is
w(s) = β1Sγ1 and the open one is:
v(s) = β s + − [2.120]
ĸ
The remaining constants β1 and β4, as well as the optimal closing and
opening policy represented by ∗ and ∗ are:
∗ ( )
β = ( )
∗ [2.121]
∗ ( )
β = ( )
∗ [2.122]
( )
s∗ = γ [2.123]
( ) ( )
∗
and ∗ =x [2.124]
where e = k1 – , b = - k2 – , d = and x, the ratio of the price of

the raw material for which the operation is closed and open, is the solution of
the following equation:
( )( ) ( )( )
= [2.125]
( ) ( )
When γ < 0 and the spot is higher, the value of the closing option tends to
zero. When the price is low and no policy has been used to counteract it, the
losses recorded on the open operation are more profitable than the
disbursements related to its closure. However, when prices are high and
under the same condition, it is the opposite that is observed and, during s*2, it
is the worst time to open the operation since one would spend money k2,
which represents the farthest distance between the curves W (value of the
closed concession) and V (value of the open concession). When operation
opening and closing costs tend to zero, s*1 and s*2 approach the same value.
When the cost of closing the operation becomes high, the closing option is
futile and, ultimately, the goal is to ensure that the opening value of the
operation approaches the current value of cash flows. Variations in closing
11 This is necessary for the current value of future costs to be finite.

costs, due, for example, to a government policy, alter the optimal policy of
closure of the operation, s*1. However, this also affects the investment
decision because of the change in the current value of future cash flows.
Such effects, or those induced by changes in a tax system, must be
immediately analyzed.
2.3.2.2. The investment decision of a project in the natural resources

sector
The investment decision12 requires comparing the current value of the
cash flows of the project to the initial investment. V(S, Q*, t) is the value of
the operation at time t of the property, Q* its stocks and S the current spot.
V(.) is the current value of the cash flows assuming an optimal operating
policy. Similarly, I(S, Q*, t) is the investment required to build a farm with a
stock Q*. The NPV of the construction of the property is:
NPV(S, Q∗ , t) = V(S, Q∗ , t) − I(S, Q∗ , t) [2.126]
The investment decision can be postponed. Thus, it is not necessarily

optimal to build the future farm only because the NPV is positive. In
anticipation of its increase, a timing option boosts the investment decision.
X(S, Q*, t) is the value of the property right to develop the operation. The
stochastic process X (.) is obtained by Ito’s lemma, using [2.86]. X (.) must
satisfy the following differential equation:
σ S X + (ρS − C)X + X − ( ρ + λ)X = 0 [2.127]
with
X(0, Q∗ , t) = 0 [2.128]
and
X(S, Q∗ , T) = 0 [2.129]
The optimal investment strategy can be assessed as a function depending

on the returns of the spot SI(t):
X S , Q∗ , t = V S , Q∗ , t − I(S , Q∗ , t) [2.130]
12 Problem initially raised by Tourinho (1979).

X S , Q∗ , t = V S , Q∗ , t − I (S , Q∗ , t) [2.131]
According to equation [2.130], the value of the holding right is the NPV
at the time of the investment. Equation [2.131] (the Merton–Samuelson
formula) maximizes SI. If the stock Q * depends on the initial investment,
the value maximizing the size of the initial stock Q* is:
V S , Q∗ , t = I (S , Q∗ , t) [2.132]
The optimal investment strategy is obtained by solving equation [2.127]

subject to conditions [2.128]–[2.132]. The optimal time to invest
corresponds to the series of critical spots S1(t) described in [2.130] and
[2.131]. The optimal amount for investing is [2.137]. The valuation of cash
flows is a prerequisite for analyzing the investment decision.
Consequently, to determine the right time to invest, Brennan and

Schwartz have developed a valuation method for a natural resource
operation, the cash flows of which depend on the price of a volatile
underlying. An optimal management model through an arbitrage portfolio
analyzes the investment decision in highly variable situations in which the
distribution of future cash flows is not given exogenously but can be
determined by managerial future decisions. However, because of the
amplitude of its variations, the price parameter of the underlying implies
certain instability as to the value of the concession. By focusing on defining
the value of an operation in order to establish an appropriate moment to
invest in its development, it is possible to agree on a valuation model
focusing on the volatility of the underlying.
2.3.2.3. Valuation based on the volatility of the underlying in oil

concessions: offsets and timing of development
The profitability of operating an oil well faces uncertainty and the
continuous study of new information. The options theory approach allows
the notion of volatility to be incorporated (Mason and Merton 1985). Siegel
et al. (1985) draw an analogy between oil well reserves and share calls to
portray the parameters influencing the optimality of the investment
decision13. Just as the call option gives the holder the right to buy a share by
paying the exercise price, the oil well reserve gives its owner the right to
13 The authors take as an empirical example the values applied to the United States in the
Gulf of Mexico in the late 1980s.
acquire and operate a concession by paying the cost of development. Thus,

each parameter of the financial option corresponds to a variable
characterizing a petroleum reserve.
Stock call options Reserve in development

Current share price Current reserve value
Variance in the rate of return of the share Variance in the rate of change of the value
Exercise price Development cost
Duration before maturity Conditions of abandonment
Risk-free rate Risk-free rate
Dividend Net profit (deficits)
Table 2.2. Comparison of valuation model variables

for stock options and developing oil reserves
Reserves of natural resources are relatively liquid assets. Transaction

prices can be assimilated to the market value of the reserve. Even though the
latter is not listed on the stock market, estimates are provided by discounting
the expected profits, deducting taxes and endowments. Over the 1981–1982
period, Gruy et al. (1982) estimated the average value of oil wells at
$12 per barrel.
As with equities, the standard deviation of reserve market prices is

estimated based on past data. The standard deviation of the rate of change in
crude oil prices is a reference for calculating the rate of change in concession
values. This implies that the ratio of the value of the crude oil price to that of
developed reserves is relatively constant14. Over the 1974–1980 period, the
annual standard deviation (σ) of the cost of refining crude oil was 14.2%15.
In order to predict statistically the evolution of the crude oil price from 1981,
Table 2.3 assumes two reference volatility rates: the one actually observed
over the 1974–1980 period and an upward-thought rate assumption.
14 A study by Gruy shows that the value of developed reserves tends to be equal to one-third
of the price of a barrel of crude oil. This relationship has been true for a number of years.
15 Calculation based on monthly data; the confidence interval adopted is 95%.
σ = 14.2% σ = 25%
Year Low High Low High
1 27.37 48.30 21.56 58.62
2 24.57 54.86 17.31 71.21
3 22.67 60.63 14.58 82.44
5 20.04 71.36 11.05 103.45
10 16.18 97.51 6.54 154.42
Table 2.3. Forecast of the crude oil price per barrel

calculated according to standard deviation
Year 0 is 1980; the price per barrel of the year was $36.
Note: Future prices are estimated from a 95% confidence interval

assuming the log-normality of the barrel price:
ln ~ − , √ [2.133]
where:
– N(.,.): normal distribution;
– x: expected rate of increase in the price of crude oil;
– St: price of the crude oil at time t.
The development cost is calculated by applying a low discount rate16,17
after tax and then deducting depreciation expenses from tangible assets.
The risk-free rate is the after-tax return on OAT securities. Skelton

(1983) shows that, in the case of long-term state bonds, the marginal tax rate
for the 1974–1980 period is 25%. The marginal tax rate on short-term bonds
is 50%. Taking an average rate of 37.5%, the risk-free rate is 1.25%
(Trigeorgis 1986).
16 Developing a reserve of natural resources takes time, hence the need to update
expenditures.
17 Development costs are relatively low risk, but the risk-free rate is not appropriate, as there
is a risk associated with the cost of labor and materials.
Just like a holder of a dividend-paying share, the owner of an oil well

concession receives income. Taking the dividend rate into account reduces
the value of a share call. Thus, oil reserve investors must estimate the rate of
profit (p) as a percentage of the market value of the reserve. The estimate of
this rate requires the following assumptions:
– the value per barrel of a reserve (V) is equal to one-third of the crude
oil price (S), i.e. V/S = 0.33;
– operating costs per barrel (OC) are on average 30% of the crude oil
price (S), i.e. OC/S = x = 0.3 (assumed constant);
– endowments (D) represent 20% of the crude oil price (S),
i.e. D/S = y = 0.2 (assumed constant);
– the production rate (g), i.e. the percentage of resources extracted each
year from the total remaining in the reserve, is 10%, i.e. g = 0.1;
– P = net profit per barrel;
– t = corporate tax rate = 0.46.
Knowing:
Profit = [(production rate) × (profit per barrel)]
– [(production rate) × (value of the reserve)] [2.134]
and
p= [2.135]

We have
P = S – OC – (S – OC – D)t [2.136]
P = S(1 – x) – 0.46S(1 – x – y) [2.137]
By replacing S with 3V:
P = 3V(1 – x) – (0.46.3V(1 – x – y) [2.138]
P = g[0.62 – 1.62x + 1.377y] [2.139]

P = 0.1[0.62 – 1.62 × 0.3 + 1.377 × 0.2]
P = 4.1% [2.140]
Thus, holding a concession means holding a share with a dividend

entitlement of 4.1%.
The holder of stock options receives the share(s) immediately after

paying the exercise price. The owner of concessions must wait for the
completion of his/her development before enjoying his/her investment. Thus,
the exercise price is modeled as a payment equal to the current value of
development expenses. In fact, the time lag leads one to think that one
receives the current value of the developed concession after having paid the
current value of the development expenses. They are calculated by
discounting the value of the reserve developed by the rate of profit. If the
rate of return of a concession is r*, the expected return for the investor is
r* – p. Suppose the development lag at t’ years. The current value of the
reserve V’ in t’ years is:
V = V × e( ∗ )
 e ∗
= V  e
[2.141]
Thus, if the development lag is about 1 year as in the Gulf of Mexico, the
current value of the reserve developed when the barrel is worth $12 is
$11.52:
V’ = e–0.041 × 1.0 × 12.2 = 11.52 [2.142]
The longer the development lag, the lower the value of the concession.
On the other hand, the owner of a reserve in development decides

whether to exercise the option or not, i.e. to operate the concession or not. If
the ratio18 C = is above the volatility, it must be exercised. Thus, the
authors provide an optimal timing rule similar to that which determines the
exercise of a similar call option entitling to a continuous-time dividend at a
given rate.
18 V’ is the current value of the developed reserve after the time lag, and D is the
development cost.
The different parameters studied make it possible to refer to an example

of oil well concession valuation based on a stochastic differential equation.
The characteristics of the reserve are:
– the expected output is 100 million barrels of oil;
– the current value of the development cost is $11.79 per barrel;
– the development lag is 3 years;
– the abandonment of the reserve is possible after 10 years;
– the expected standard deviation of the value of the reserve is 14.2%;
– the profit ratio is 4.1%;
– the value of the concession today is $12 per barrel.
, ×
The current value of the concession V’ is V = × 12 =
10.61 $per barrel.
.
The ratio of development costs is = = = 0.90.
.
Value of concession in development = Value of the option for $1 of

development cost × Total development cost = 0.05245 × 11,179,000
= 61,840,000.
σ = 14.2% σ = 25 %
V*/D T=5 T = 10 T = 15 T=5 T = 10
Out the money
0.7 0.00655 0.01322 0.01704 0.04481 0.07079
0.75 0.01125 0.01966 0.2410 0.05831 0.08650
0.80 0.01810 0.02812 0.3309 0.07394 0.10392
0.85 0.02761 0.03894 0.04430 0.09174 0.12305
0.90 0.04024 0.05245 0.05803 0.11169 0.14390
0.95 0.05643 0.06899 0.07458 0.13380 0.16646
In the money
1.00 0.07661 0.08890 0.09431 0.15804 0.19071
1.05 0.10116 0.11253 0.11754 0.18438 0.21664
1.10 0.13042 0.14025 0.14464 0.21278 0.24424

1.15 0.16472 0.17242 0.17599 0.24321 0.27349
Table 2.4. Value of the option for $1 of development cost
Thus, even though a concession may not be profitable today, the right to
develop it in the future has a positive value of approximately $62 million.
Using the same data as in the previous example and applying variations
in standard deviation, maturity periods and discounted values, the value of
the concession in development shown in Table 2.5 is observed.
σ = 14.2% σ = 25%
V*/D T=5 T = 10 T = 15 T=5 T = 10
0.7 7.72 15.59 20.09 52.83 83.46
0.80 21.34 33.15 39.01 87.18 122.52
0.90 47.44 61.84 68.42 131.68 169.66
1.00 90.32 104.81 111.19 186.33 224.85
1.10 153.77 165.35 170.53 250.87 287.96
Table 2.5. Value of the concession in development (in millions of $)
The longer the maturity period and the greater the standard deviation of
the underlying, the higher the value of the concession. On the other hand, the
higher the out the money values, the higher the change in the value of the
concession between two maturity periods, especially if the volatility
also increases. For example, with a C of 0.7 for a T of 5, the shift of σ
from 14.2 to 25% increases the value by almost 600%. Consequently, the
more the price of the barrel is variable, the more variable the value of the
concession.
As a result, the authors focused on adapting the theory of financial

options to operating options in the oil industry. By excluding the forecasts of
barrel prices that are too uncertain and discounted (except for the calculation
of development expenses), Siegel, Smith and Paddock provided a timing
response to the investment problem in oil well concessions based on price
volatility. According to Kaplan and Weisbach (1992), the reasons for

deciding to abandon an investment project may come from a shift in
strategic direction.
2.3.3. Valuation of the abandonment option by investors
Lang et al. (1995) justify the exercise of the abandonment option to the
extent that the company enters a debt reduction logic. Moreover, as
suggested by John and Ofek (1995) as well as Comment and Jarrel (1995),
the abandonment can result from a desire to refocus the activity on the part
of the company. In order to estimate the exit value of a company, Berger
et al. (1996) explain that US investors incorporate the abandonment option
price into their equity valuation. However, if the approach is relevant, it
turns out that, in a pragmatic way, the question of the accuracy of the pricing
of this option remains unresolved. In fact, the exit value is usually negotiated
confidentially between the various stakeholders involved in the transaction;
the market knows precisely the price once the transaction is concluded.
Clark et al. (2010) study 144 divestitures of British companies listed in

the LSE19 between 1985 and 1991. The objective is to find out whether UK
investors are valuing options for abandoning the assets of their company
(similar to US put options) in exchange for an exit value. If necessary, the
authors wish to take an interest in the methodology of their pricing. Finally,
Clark, Gadad and Rousseau wonder if a possible bad pricing is the
consequence of a lack of information related to the fact that the negotiations
concerning the takeover are private and/or if other reasons can justify this
phenomenon. The three researchers consider that the valuation of this type of
abandonment options results from a process of spreading the value of an
asset that can be sold. This value Vt, which is the current value of future cash
flows, follows the following geometric Brownian motion:
dV(t) = α V(t)dt + σ V(t)dz(t) [2.143]
where:
– α: growth rate of the value of the asset;
19 London Stock Exchange.

– dz(t): the Wiener process having a zero average and variance equal to
dt;
– σ: standard deviation of the asset.
Also, the exit price S follows a geometric Brownian motion:
dS = π S(t)dt + ω S(t)dw(t) [2.144]
where:
– π: growth rate of the value of the asset;
– dw(t): the Wiener process having a zero average and variance equal to
dt;
– ω: standard deviation of S.
Since both Wiener processes are correlated, it is possible to write:
dz(t). dw(t) = ρ. dt [2.145]
Consequently, the value of the abandonment option denoted F is a

function of V and S. After taking into account the change of variable =
and using Ito’s lemma, F is the result of the following second-order
differential equation:
.
F= + + SK g [2.146]
with
– = − , where Rg is the required rate of return for g;

– = − − + ;
( )
– = ;
– = −2 + ;
∗
– =− ( )
;
∗ ( )
– = ( )
, which corresponds to the optimal exit value;
– γ: probability of occurrence of an event causing the exercise of the

abandonment option. This event is random and rare. It takes place, in
principle, before the report V over S reaches, for the first time, the level of
g*. It may be a crisis of liquidity, reorganization, hostile takeover bid or a
change in regulation. According to Clark, Gadad and Rousseau, γ is
proportional to the variance of the return of the company to the extent that
the large variations in return are the result of situations such as those that
characterize the existence of this variable.
The three researchers find that an increase of α, r and/or ρ increases the
value of g* and decreases that of F. On the other hand, an increase of π
and/or κ decreases the value of g* while increasing F. In addition, at the time
of the announcement of the abandonment of the asset, F is equal to S*.
In response to their question about a possible error regarding the pricing

of the abandonment option, Clark, Gadad and Rousseau distinguish two
scenarios:
– in a situation of market efficiency, the asset selling price is public
information. As a result, investors are able to make a fair valuation;
– otherwise, the information about the exit value remains confidential.
Thus, the market is likely to make valuation errors.
The three researchers’ empirical study focuses first on calculating the

abnormal returns of their sample. They define them as the difference
between a return observed at a specific moment corresponding to an event
date and the return obtained from the formula of the market line: the
coefficients resulting from a linear regression over the observation period.
They retain an observation period of 118 days in addition to a 61-day event
period. The latter begins 30 days before the announcement date of a
disinvestment and ends 30 days after it has taken place. Then, the authors
add the abnormal returns of the event period to obtain cumulative abnormal
returns. In addition, they calculate abnormal capital gains by applying the
accumulated abnormal returns to the market capitalizations recovered on the
eve of the respective exit announcements.
Thus, Clark, Gadad and Rousseau observe that abandonment options are
undervalued by about 1% due to early exercise and that the 22% rate of
abnormal capital gains is justified by this undervaluation. On the other hand,
the options approach could make it possible to value investment projects that
could generate growth opportunities.
2.4. Growth option resulting from investment decisions and

acquisition strategies
The financial literature reveals that the diversification of activity,

resulting from investment decisions and strategic transactions in the control
market, generates a diversification discount for the company at the initiative
of the offer. The reasons are mainly related to agency problems and lower
future growth prospects than those of companies operating in a single
business segment. As a result, Long et al. (2004) explain that companies
with growth options prefer to delay decision-making.
Interactions between financing and investment decisions favor the

existence of growth options. In fact, Childs et al. (2005) argue that financing
choices regarding debt decisions and possibilities to increase debt or
possibilities to reduce it give shareholders the opportunity to overinvest or
underinvest according to the application of an exercise strategy.
Under these conditions, the shareholders wish either to recover on their

behalf the wealth of the creditors (over-investment) or to avoid that their
wealth is developed for the benefit of the creditors (under-investment).
Resulting agency conflicts reduce enterprise value, as well as optimal
leverage effect while increasing credit risk.
The growth options are found, if any, within the acquisition strategies to
the extent that the potential buyer would express the wish to buy those that
are missing but that the target has. Smith and Triantis (1995) develop this
idea by conceiving that two companies are able to benefit from a common
development resulting from a simultaneous sharing. In fact, the potential
buyer can provide the missing resources to the target company that offers its
opportunities. Value creation occurs when synergies related to these
interactions are found. Thus, research carried out after the application of this
theory empirically proves that this type of growth potential is related to
acquisition strategies.
2.4.1. Company profiles justifying growth option value
From their various studies, Montgomery (1994), Scharfstein and Stein

(2000), as well as Rajan et al. (1998) believe that companies with diverse
activities encounter problems with agency theories. These managerial
difficulties then explain why, in this type of company, a diversification
discount is noted. However, Chevalier (1999) seeks to prove that
diversification of activity is not synonymous with value destruction. In fact,
by examining the behavior of companies that have merged, it shows that it
does not evolve before and after the transaction. The announcement of a
change aimed to diversify the activity even results in positive returns. Campa
and Kedia (1999) argue that it is not diversification that is destructive of
value. According to them, it is the specific characteristics of the companies
that justify their decision to diversify and, beyond that, the application of a
haircut. In this context, they show that once a company is controlled, the
diversification discount becomes so low that it disappears in some cases.
Bernardo et al. (2000) focus on proving that real options can explain all
or part of the existence of the diversification discount. Through their
empirical study, it appears that the market value of companies operating in
more than one business segment is less than the sum of the market values of
companies operating only in one of the corresponding industries. In fact, the
market value of companies in an industry includes the value of
diversification options while companies with several businesses have
exhausted their growth options. Three results support this conclusion:
– they find a positive correlation between the value of the growth options
of a company and the number of new industries in which the company could
invest;
– they observe that companies in more than one business segment have
fewer growth options than companies with only one business in the same
segments. They find a justification in the fact that the former have, compared
to the latter, lower research and development and tangible fixed asset
expenditures, as well as higher cash flows and structural size;
– with reference to the parameters of real options, they find that the
diversification discount increases, as research and development expenditures
and market volatility increase and decrease with the age of the company.
Long et al. (2004) explain that the current value of growth options is even
greater as the company invests its expenses in research and development,
when it is subject to high growth rates and past volatility levels and when it
is listed on NASDAQ. To justify this, they find a negative correlation
between the level of investment and the current value of real options. This
implies that companies with more growth options further delay their decision
to undertake investment projects. Moreover, they observe a low level of the
value of the growth option when the company has diversified activities. In
this context, they find that a company operating in a weakly competitive
environment is more willing to postpone the decision-making time to invest,
certainly because there is little risk that competitors will question the value
of the real option.
According to the researchers, the value of a company is equal to the

valuation of its assets, to which we must add the value of future growth
prospects related to the launch of new products or to the improvement of
market conditions. Companies with large PERs are considered to have some
growth potential. Thus, their market capitalization incorporates the value of
this type of real option, i.e. the possibility of investing in value-creating
investors in the future.
They carry out a study based on financial data of 619 companies for the
year 1992 and 871 companies for the year 1997. It consists of determining
the implicit value of the growth options held by the listed companies in their
sample. To do this, they subtract the market capitalization value from the
current value of future operating cash flows (after deducting the amount of
the debt). As a result, the interactions between financing and investment
decisions can also explain the presence of growth options.
2.4.2. Growth option value related to interactions between

financing and investment decisions
Childs et al. (2005) examine the interactions between financing and

investment decisions by integrating the concept of growth options. In fact,
they consider that a company holding a portfolio of assets (the value is noted
A) has the possibility to exercise or not a growth option allowing it to invest
in a new portfolio of assets (the value is noted G). The underlying therefore
corresponds to the value of the assets already held, the exercise price to the
amount of the debt and its maturity date. Shareholders are then encouraged
to invest more or less in the business, depending on whether the option
increases or decreases. This is similar to the possibility of postponing the
investment. Investment distortions reduce the value of companies as well as

their optimal leverage and increase credit spreads. The authors find that the
reduction in debt maturity mitigates these investment distortions. In this
context, we have
()
= (μ − δ )dt + σ dZ (t) [2.147]
()
()
= (μ − δ )dt + σ dZ (t) [2.148]
()
and
dZ dZ = ρdt [2.149]
where:
– µA and µG: respective expected constant rates of return for asset

portfolios A and G;
– δA and δG: respective constant dividend rates for asset portfolios A and
G;
– σA and σG: respective volatilities of asset portfolios A and G;
– R: correlation coefficient between asset portfolios A and G.
The value of the asset portfolio in place (A) represents the current value
of the cash flows generated by these assets after deduction of taxes and
without taking into account the cash outflows related to the repayment of the
debt. Moreover, the authors assume that δA is not affected by the level of
indebtedness. Thus, if the total amount payable δA.A is less than the after-tax
debt service amount. The deficit is financed by a new contribution from the
shareholders. The previous interpretation is the same for asset portfolio G,
except that shareholders would forego the additional cash flows of new
investments if the growth option relating to asset portfolio G is not
exercised. Childs, Mauer and Ott further explain that the optimal amount of
debt and its maturity are determined by a compromise that takes into account
the tax benefits related to interest, the various costs related to this means of
financing, and the relative costs of agency conflicts between shareholders
and bondholders. They specify that the shareholders have the possibility of
abandoning the company to its creditors, which also supposes taking into
account costs of bankruptcy. In fact, in the event of default, equity is

assumed to be zero and creditors take control of the structure.
In the event of exercise of the growth option, the model suggests

replacing new assets with a fraction γ of the assets held at the base by the
company. In this context, if γ = 0, the exercise of the real option leads to
replacing “old” assets with new ones. The exercise policy of the growth
option maximizing equity value consists of a sequence of decisions made
over time on the A, G, F and m values. Assuming this option is not yet
exercised; it is defined by a set of exercise policies such as:
Φ = ϕ(G, A, F, m, t) ∈ O, I ; G ≥ 0, A ≥ 0, F ∈ L, m ∈ M, t ∈ 0, T
[2.150]
where:
– Φ: value of the growth option;

– F: amount of the debt;
– m: maturity of the debt;
– t: time, i.e. the maturity of the option.
Thus:
ϕ(G, A, F, m, t) = O if the option is not exercised [2.151]
ϕ(G, A, F, m, t) = I if the option is exercised [2.152]
The choice of financing policies according to the level of indebtedness

(F ∈ L) and its maturity (m ∈ M) depend on the following equations:
L = F(G, A, m, t) ≥ 0; G ≥ 0, A ≥ 0, m ∈ M, t = 0, m, 2m, … , T − m
[2.153]
and
M = m(G , A , , 0) ∈ , ,…, ; G ≥ 0, A ≥ 0, ≥ 0, = 0
[2.154]
Note that E ( , , , , ) is the market value of equity if the growth

option is not yet exercised, and E ( , , , , ) is the market value of
equity if the option is exercised. By applying the partial differential

methodology, we then have
1
σ A E + 2AGσ σ ρ E +σ G E
Max 2
+(r − δ )A E =0
ϕ ∈Φ
+(r − δ )G E + E − rE + δ A − cF(1 − τ)
[2.155]
1
+2 +
2
Max +( − ) =0
ϕ ∈Φ
+( − ) + − + (1 − )
+ − (1 − )
[2.156]
where:
– the S index: exercise policy of the growth option;

– τ: corporate tax rate;
– if the option is not exercised, A − F(1 − ) represents the cash
flows attributable to the shareholders;
– if the option is exercised, (1 − ) A + G − F(1 − ) represents
the cash flows attributable to the shareholders;
Solving the above two equations, we have
E G A, F , m , t , A, F , m , t =
E G A, F , m , t , A, F , m , t − K , A ≥ 0, t ∈ [0, T] [2.157]
E G A, F , m , t , A, F , m , t =
E G A, F , m , t , A, F , m , t − K , A ≥ 0, t ∈ [0, T] [2.158]
where:
– K represents the exercise price of the option;

–G ( , , , ) and G ( , , , ) represent the critical values of

the underlying assets of the growth option for which shareholders exercise
optimally their right;
– G and G are not fixed exercise points, but exercise limits that depend
on A, FS, mS and t;
– FS and mS indicate that the policy of exercising shareholder growth
options has an influence on the choice of financial policy.
The level of debt and the associated maturity are the solutions of the
following maximizations:
Max
E G ,A ,F ,m ,0 +
F ≥ 0, m ∈ M
(1 − κ)D G , A , F , m , 0 [2.159]
Max
E G, A, F , m , t + (1 − κ)D G, A, F , m , t − F [2.160]
F ≥0
where:
– κ: share of debt issuance costs in the market value of the new debt
issued;
– t = m, 2m,…, T – m;
– j = O, I.
In equation [2.159], the company chooses the initial value of the debt F
as well as its maturity to maximize, at time t = 0, the sum of the market
value of equity E and the market value of net debt issuance of issuance
costs D .
Assuming that the company chooses mS < T and depending on the status
of the exercise policy (O or I) at maturity dates of the debt, in equation
[2.160], the company chooses a sequence of face values that maximizes the
sum of the equity value and the market value of net debt issuance of issuance
costs minus the repayment of the nominal amount of the maturing loan.
The values of equity and debt must also meet the boundary conditions in
bankruptcy. In this case, the shareholders must choose the right time to
declare the company in default and transfer ownership to the creditors. Thus:
E G, A G, F , m , t , F , m , t = 0, G ≥ 0, t ∈ [0, T], j = O, I [2.161]
D G, A G, F , m , t , F , m , t = (1 − b)V G, A G, F , m , t , t , G ≥
0, t ∈ [0, T], j = O, I [2.162]
where:
– the B index: bankruptcy situation;

– b: share of the costs of bankruptcy in the enterprise value;
– for a certain level of G, A ( , , , ) ≥ 0: the optimal value of the
assets in place for the shareholders to abandon the company to the creditors;
– ( , ( , , , ), ): market value of the indebted company in
bankruptcy.
Finally, the values E rs and E must satisfy on the horizon T the

following conditions:
E G, A, F , m , T = Max A − F + Max G − γA − K , 0 , 0 [2.163]
E G, A, F , m , T = Max (1 − γ)A + G − F + Max γA −

G − K ,0 ,0 [2.164]
If the growth option is not exercised at time T, condition [2.163] indicates

that the shareholders will hold the maximum of the net value of the assets in
place, A − F , to which we must add the value of the payment of the
exercise of the growth option. If the company is bankrupt, the equity value is
zero. The interpretation is identical with respect to condition [2.164], except
that there is a change in the value of the exercise price of the shareholders if
the option is exercised.
Childs, Mauer and Ott then examine the costs associated with
maximizing the equity value. To do this, they design a model in which an
idealized situation is taken into account. In fact, they assume that the signing
of new investment contracts involves no cost, making it easier for the
company to make decisions. The latter can then consider its investment
policy in terms of growth options and maximize its enterprise value.
Considering the index f as the best choice of investment policy, let us note
that the function ( , , , , ) is the market value of the company
(equity and debt) if the growth option is not exercised and the function
( , , , , ) is the market value of the company if the growth option is
exercised. By applying the partial differential methodology, we then have
1 +2
Max 2 +
=0
ϕ ∈ Φ, ∈ L, ∈ M +(r − δ )A + (r − δ )G V
+ − rV + δ A + τcF
[2.165]
1 +2
2 +
Max
+(r − δ )A V + (r − δ )G V =0
ϕ ∈ Φ, ∈ L, ∈ M
+ V − rV + (1 − )δ A
+ G + τcF
[2.166]
where ϕ refers to all of the exercise policies that maximize enterprise value
and F and are the corresponding financial policy choices.
Enterprise values V and V meet the following conditions:
V G A, F , m , t , A, F , m , t = V G A, F , m , t , A, F , m , t −
K , A ≥ 0, t ∈ [0, T] [2.167]
V G A, F , m , t , A, F , m , t = V G A, F , m , t , A, F , m , t −
K , A ≥ 0, t ∈ [0, T] [2.168]
The boundary conditions of the initial debt issuance, as well as its

maturity dates are
V G ,A ,F ,m ,0 =
E G , A , F , m , 0 − (1 − κ)D G ,A ,F ,m ,0 [2.169]
V G, A, F , m , t = E G, A, F , m , t + (1 − κ)D G, A, F , m , t −
F , t = m, 2m, … , T − m, j = O, I [2.170]
Finally, the enterprise value satisfies the following conditions:
V G, A, F , m , T = 1 − bI Max[A, (1 − γ)A + G − K ] [2.171]
V G, A, F , m , T = (1 − )Max[A, (1 − )A + G − ] [2.172]
The authors then perform numerical simulations and find that

shareholders would benefit from overinvesting in the growth option in the
case where the investments that can be conducted (underlying assets) are
more risky than the assets in possession of the company and even more so if
they are given the opportunity to substitute a portion of existing assets with
new assets. The value of equity then increases through a transfer of wealth
between creditors and shareholders. The exercise of this option at a
sub-optimal level therefore reduces the enterprise value and increases the
credit spread. As a result, the authors identify an agency conflict between
different stakeholders of the company. The agency cost of this
overinvestment negatively affects the optimal level of indebtedness. In
addition, shareholders would tend to underinvest in the growth option if the
decision is motivated by an expansion of the asset portfolio. They will prefer
not to exercise the option when the company holds risky debt for not having
to share wealth generation with creditors. As a result, the enterprise value
decreases, the debt margin increases and the optimal debt ratio decreases.
In other words, the financing decisions of the company include the choice
of the initial level of debt and its maturity, as well as the option of increasing
or reducing the level of indebtedness in the future. Depending on the
characteristics of the growth option, shareholders have the opportunity to
overinvest or underinvest according to an exercise strategy aimed to
maximize enterprise value. These investment distortions are motivated by
the shareholders who wish to either transfer, in their favor, the wealth of the
creditors (overinvestment) or avoid the development of wealth for the
benefit of the creditors (underinvestment). These agency conflicts
significantly reduce the value of the company, as well as the optimal
leverage effect and increase the credit risk. Interactions and the birth of
growth options can also occur in acquisition strategies. In fact, a target
company may hold growth options that are lacking to the potential buyer
who wishes to recover them.
2.4.3. Acquisition strategies by the real options approach
According to Smith and Triantis (1995), two companies may share

common development bias within a given sector. In fact, acquisitions are
often synonymous with growth options through the interactions between the
buyer and the target. In other words, the target may have growth options that
the buyer lacks, while the latter may have growth options that he/she cannot
exploit without taking control of another company. It is thus possible to buy
a company present in a particular business segment, but it does not have the
means to maintain its level of growth. The potential buyer – with the ability
to provide the target company with the missing resources – can then invest
less than the estimated value of the company once bought. Thus, synergies
or new acquired distribution chains can lead to value creation through new
investment opportunities.
Kester (1984) provides the first set of empirical estimates of the value of
growth options. It measures the growth value of a company as the difference
between its market value and the current value of its cash flows. The growth
value expressed as a percentage of the market value can, according to him,
reach the threshold of 90%.
McDonald and Siegel (1986) believe that the carry option of an

investment also relates to corporate acquisition strategies. The model of
choice they build should allow the company to define the ideal time frame
for investing in a project of a given size. By performing simulations, they
analyze the value lost during the waiting period compared to the value
gained during the same period. They conclude that temporal considerations
are quantitatively important for a multitude of parameters. In other words, a
too hasty time frame can lead to a loss of value of the order of 10 to 20%.
Ideally, it is optimal to wait for the moment when the gains are twice the
investment costs knowing that the greater the uncertainty related to the
income of the investment project, the more the company will require a high
current return of the project to invest.
Folta and Miller (2002a) examine the factors that influence the decision
to acquire shares from a sample of 285 companies specializing in the
biotechnology industry where research is dominant. The decision is to
choose between flexibility and commitment. The options theory they
propose to consider incorporates the effects of uncertainty, the assessment of
developing technologies and the threat of intense competition. The
resolution of uncertainty about the decision to invest in high added-value
technologies is all the more motivated if the underlying growth option is
subject to competition. They conclude that although it seems appropriate to
delay investment in uncertain conditions (share purchases are more easily
operable when uncertainties are low), there may be opportunity costs to
waiting for exercise real options: Companies can forego cash flows or
learning opportunities in addition to being outpaced by competitors. The
opportunity costs of delaying the investment correspond to the dividends not
received during the term of the option. Thus, in the absence of a dividend,
Foltat and Miller (2002b) observe that the best strategy is always to wait
until the maturity of the option. In other words, dividends or opportunity
costs are the main reason for early exercise.
The learning process is also considered by the works of Dapena and

Fidalgo (2003). The latter study the acquisitions with an approach consistent
with that of real options, that is to say, by considering the value of the
control premium sequentially and not uniquely in time. The authors consider
a waiting option in which the learning process lies and a growth option
because the acquisition offers growth opportunities. Thus, a significant
minority takeover gives access to information and offers the possibility of
being present in the management bodies while a majority shareholding
confers control rights.
Inspired in particular by the work of Kester (1984), Reuer and Tong

(2007) empirically study the values of the growth options of 293 companies
divided into 19 industries between 1989 and 2000. On average, the real
options represent 43% of the market value. However, both researchers find a
significant heterogeneity in their results. For example, they report an average
of 54% in the electrical equipment sector and an average of 22% in the
textile sector. The major conclusions of their analysis concern the nature of
investments that may contain more value related to growth options. In fact,
Reuer and Tong distinguish that the investments of companies in research
and development on the one hand, by forming joint ventures on the other
hand, most integrate the potential of values of growth options. These
observations stem from the fact that research and development projects
operate in stages and are therefore likely to generate value based on future
business investment opportunities. With regard to joint ventures, the authors
note that, for the entire population studied, only those that are minority in the
capital of the investee company can capture the most value related to growth
options. They explain this phenomenon by starting by recalling that,
according to the work of Reuer and Leiblein (2000), joint ventures do not
reduce the risk of companies because of the organizational complexity they
generate. Then, Reuer and Tong suggest that small joint ventures can be a
particularly rewarding means, heralding future commitments. This
interpretation is similar to the work of Hurry et al. (1992). The latter noted
that Japanese investors are following an optional strategy with small
investments to capture a wider range of future growth opportunities.
Collan and Kinnunen (2009) illustrate the strategic interest of real options
in the acquisition process by relying on the acquisition in 2002 of Partek Inc.
by Kone Inc. The company initiating the offer was able to create value by
anticipating the possibility of splitting the assets and activities of the target
while considering sequential abandonment options. In addition, the providers
of securities, namely the initial shareholders of Partek (including the Finnish
government), neglected in their assessment the flexibility of this type of
development without paying attention to the value of strategic options. This
case echoes the article by Alvarez and Stenbacka (2006). In fact, they expose
different types of real options present in mergers and acquisitions, including
the sale of units of the acquired company. The resulting divestiture option is
considered sequential. The synergies resulting from the reorganizations must
be a factor to be taken into account in the definition of the optimal time
frame and acquisition prices.
Before the Kone and Partek transaction takes place, Collan and Kinnunen
(2009) note that the company initiating the offer has historically grown
through external growth within a relatively mature industrial sector
(elevators and escalators). In this context, the group is inclined to look for
targets to restructure its business. Partek is a conglomerate of engineering
companies whose stock price is, at this time, less than the substantial value
of the company. In 2002, Kone launched a hostile takeover bid for all of
Partek’s activities (including those that did not correspond to its core
business) and, under the terms of the negotiations, the price paid was same
as €1.45 billion. The workforce of the target was approximately 12,450 and
the turnover was about €2.74 billion, which is about the size of Kone. The
activities that Kone considers compatible with its core business – namely
elevators and escalators with their handling activities – have been valued
between €960 and €1.04 billion and have integrated a separate division of
the group, renamed in 2004 Kone Cargotec. This concerns Hiab companies
(valued between €440 and €490 million) and Kalmar Industries (valued
between €520 and €550 million). Then, between 2003 and 2004, Kone
“exercised abandonment options” by selling, for a total amount of €1.15
billion, various units of Partek considered non-strategic. At the end of 2004,
Kone purchased MacGregor Inc. to recover its marine handling and
maintenance services. In June 2005, Kone divided the group into two
entities:
– Kone Corporation, which grouped together the group’s flagship
activities (elevators, escalators and automated doors);
– Cargotec Corporation, which encompassed the activities of newly
acquired companies, namely Hiab, Kalmar and McGregor.
The stated objective of this split was to form two more efficient
synergistic companies with greater growth potential that enhance the
shareholder value appreciation of the group. In 2007, the total workforce of
the Kone Group was approximately 32,500 and the turnover was €4.08
billion. Thus, unlike Partek, Kone’s acquisition experience has allowed it to
make rapid structural and strategic changes. Consequently, as mentioned by
Boer (2002), the value of a company does not only include the cash flows
generated by its assets, namely the economic value, but also the strategic
value including the human and intellectual capital that allows us, thanks to
know-how, to turn plans into economically viable operations.
Agliardi et al. (2016) develop a model for analyzing changes in capital

structure after a merger–acquisition transaction that incorporates the effects
of synergies and operational growth options. Then, they test their model on a
large panel of 1,121 acquisitions in the United States between 1980 and
2010. Their work shows that there are implications and adjustments between
financial leverage, growth opportunities and merger gains within the
merger–acquisition process. Their model results in new predictions for
acquisitions that have been made in industries other than those of the
acquiring company by taking into account changes in levels of indebtedness
and merger gains related to the effects of diversification and growth options
for the buyer and the target. The value of the latter depends on the
differences in volatility between companies and the inclusion of the costs of
bankruptcy. In particular, the model predicts that, after the transaction,

companies that merge and have a low correlation between their cash flows
will see more merger gains while seeing an increase in their leverage. In
addition, the authors note that because of their merger, companies that
experience lower volatility and lower costs of bankruptcy have higher
merger gains and levels of indebtedness. Moreover, companies with less
correlated activities, significant growth option values, volatilities and low
costs of bankruptcy have greater leverage, which increases after the
transaction. This type of company also benefits from higher stock market
returns around merger listings. Finally, the three researchers distinguish the
existence of a “U”-shaped relationship between changes in levels of
indebtedness (between before and after the transaction) and the value of
growth options. In this context, they assume that the turnover levels for a
potential buyer A and a potential target T follow the following correlated
geometric Brownian motion:
A, T = i et = a dt + σ dz [2.173]
where:
– ai and σi > 0 are constant parameters;

– dz is the Wiener process for the company i.
The revenue processes of both companies are correlated with:
dZ dZ = ρdt et − 1 < [2.174]
Note:
– r: interest rate used for the discount;
– Ci: operational cost of the company i;
– Pi,t – Ci: REX of the firm i at time t;
– τ: corporate tax rate assumed to be constant, equal for both companies;
– M: entity resulting from the merger of A and T;
– 0 < s < 1, where s: relative share of synergies related to the reduction of
the operating costs of the entity M. If s = 0, then there is no synergy at this
level;
– eM > 1, where eM: relative share of synergies linked to the growth of the
turnover of the entity M. If eM = 1, then there is no synergistic surplus linked
to the taking of market shares.
In that case:
C = (1 − s)(C + C ) and P = e (P + P ) [2.175]
The authors also assume that merged companies may hold growth options
that have a common maturity T1. The growth factor related to growth options
is:
e , , i = A, T, M [2.176]
The exercise price of the growth option is as follows:
I , , i = A, T, M [2.177]
knowing that , > for the growth option to be exercised.
Thus, in the event of exercise of the option, the company M receives, for
a cost equal to IM,G:
P , =e , P , +P , [2.178]
In the case where the companies operate one without the other, after the
exercise of their growth option, they receive (individually), for a cost equal
to Ii,G,i = A, T:
P , = e , P , avec e , > 1 [2.179]
Considering the foregoing, Agliardi, Amel-Zadeh and Koussis specify

that it is possible to study cases where the growth options exist before the
merger and cases in which they are created at the end of the merger.
Moreover, the authors assume that there are no merger costs and incorporate
the cost of bankruptcy equal to bi, i = A, T, M. Thus, to model the process of
income trends described in equation [2.173], the authors use a
two-dimensional binomial model. Decisions are assumed to be made at each
step Δt. The parameters of bullish (u) trends, bearish (d) trends and joint
probabilities for the variations of turnover of the company initiating the offer
and the target are the following:
u =e √∆ et d = e √∆ [2.180]
P = 0,25 1 + ρ + √∆t + [2.181]
P = 0,25 1 − ρ + √∆t − [2.182]
P = 0,25 1 − ρ + √∆t + [2.183]
P = 0,25 1 + ρ + √∆t − [2.184]
where = ( − ) − c and δ is the opportunity cost parameter, such as

waiting according to the Dixit and Pindyck model (1994). The correlation
between the turnover levels of the two companies is integrated in the
probabilities. At each stage of the two-dimensional tree, the incomes of the
two companies can move jointly upwards (with the probability Puu) or jointly
downwards (with the probability Pdd) or upwards for the buyer and
downwards for the target (with the probability Pud) or downwards for the
buyer and upwards for the target (with the probability Pdu). A stronger
correlation between the turnover of the two companies increases the
probabilities of jointly upward and downward movement, respectively, Puu
and Pdd, thereby reducing the probabilities of opposing movements,
respectively, Pud and Pdu. The current leverage of the company i is defined by
the level of the coupon Ri, i = A, T, M. It is assumed that companies choose
optimal coupon levels at t = 0, thus maximizing the value of the indebted
company. As a result, they no longer modify their financial structure.
The optimal solution is the one that maximizes the value of the indebted
firm = A, T, M à = 0. Thus, by proceeding inductively from the end
horizon, the nodes of the tree are calculated, namely the values of the
company initiating the offer, the target company and the company resulting
from the merge using the following expressions:
E , = max P , − C − R (1 − τ)∆t + E , , 0 [2.185]
If E , > 0:
V , = P , − C (1 − τ)∆t + V , [2.186]
BC , = 0 + BC [2.187]
TB , = τR ∆t + TB [2.188]
D , = R ∆t + D [2.189]
V, = E , + D , [2.190]
If E , = 0:
V , = P , − C (1 − τ)∆t + V , [2.191]
BC , = b V , [2.192]
TB , = 0 [2.193]
D , = (1 − b )V , [2.194]
V, = E , + D , [2.195]
where:
– VU: non-indebted company;

– VL: indebted company;
– TB: tax benefits related to indebtedness;
– BC: cost of bankruptcy;
– E: equity value;
– D: value of the debt;
– ( ): current expected value of the variable x, namely:
x (t) = P X , +P X , +P X , +P X , e
[2.196]
In the presence of growth options, the logic is the same, except that the
value of equity includes the value of a compound option E with a maturity
of T1:
E, = max E , P − I , ,E , P [2.197]
2.5. Conclusion
Dixit and Pindyck (2001) consider that the investment opportunity that a
company seizes is akin to a financial call option. It embodies the right and
not the obligation to acquire an asset corresponding to the right of access to
the profit streams generated by a project on a date chosen in the future. If the
investment is made, the exercise of the call option is considered to be
undertaken. The managerial flexibility that real options offer is a major asset
in helping decision-making. Beyond designing models specific to each
category of options, the financial literature, which has assimilated all the
complexity that governs investment projects, also seeks to associate them.
The combination of options (and not considering them in isolation) gives
less value to the project, but gives greater flexibility to the company’s
reaction possibilities. Taking into account specific projects, based on
development phases requiring significant research and development
expenditure or on particularly volatile sectors, leads to inventing models that
optimize the right time to invest. Empirically, companies tend to wait and
see future prospects only when they find that their level of information is
more accurate. In addition, companies can use the optional approach when it
comes to external growth and financing policy. In fact, acquisition strategies
can be founded when the buyer considers the potential of the target’s growth
options. However, the diversification of activities reduces the value of these
options. Thus, companies are still encouraged to delay their
decision-making. The financial structure and agency conflicts between the
various stakeholders encourage shareholders to prefer strategies equivalent
to option exercises. Depending on the debt situation of the company,
shareholders may wish to overinvest to recover value or, on the contrary,
under-invest in order not to enrich the creditors.
After focusing on a literature review of the optional modeling of

investment choices and of the surplus value associated with the option to
invest, I considered it useful to put into practice various optional models,
such as those of Dixit and Pindyck and Magrabe, by establishing different
simulations of investment projects.
3
Data Generation Applied to Strategic

and Operational Option Models
3.1. Introduction
The different applications presented in this third chapter are intended

to verify the practicality of the methods developed in the literature
review.
Since the companies maintain the confidentiality of their investment

projects internally and, as a result, these elements are not available to the
general public, in order to carry out my calculations, I had to make prior
assumptions regarding amounts, duration and rate.
They justify the interest and usefulness of applying the real options
approach as a tool to assist investment decision-making.
3.2. Determining the right time to invest
The carry option allows the company to postpone the decision date of a
planned investment (before its maturity) provided that the elements are
favorable.

3.2.1. Application to the carry option
Assuming that a company sees the possibility of acquiring a portfolio of

assets, such as machines worth €3,600 million, the investment should
generate each year from the following year:
– either with a probability of 50%, annual cash flows of €390 million;
– or with a probability of 50%, annual cash flows of €210 million.
This difference in flow is explained by the fact that the company is

waiting for the results of the call for bids in which it has just participated. In
addition, to the extent that the investment is launched at the beginning of the
year (i.e. before the response to the call for bids and related flows in 1 year),
cash flows would be €300 million. Figure 3.1 summarizes the projected cash
flows.
390 390 390

300 where where where …
210 210 210
t=0 t= 1 t= 2 t=3 …
Figure 3.1. Evolution of cash flows of an investment project
By postponing its 1-year investment project, the company will know for
certain the cash flows generated by the project. With a discount rate of 6%,
if the call for bids is unsuccessful for the company, its cash flows will be
210 million per year. The project will then have a value of €3,500 million1.
In this case, the value of the project will be lower than the cost price
(€3,600 million) and the investment will have to be abandoned.
Considering a strategic flexibility related to the fact that the company can
postpone its investment in 1 year, the binomial approach makes it possible to
obtain another value. The project will be worth:
1 That is, 210/6%.

Data Generation 109
In t = 0:
390 × 50 % + 210 × 50%

= €5,000,000
6%
In t = 1:
– either:

= €6,500,000 with a probability of 50%
%
– or:
210
6%
In this context, the project holds:

– a capital gain of 6,500–5,000 = €1,500 million, or 30% of the value of
the project;
– a capital loss of 5,000–3,500 = €1,500 million, or −30% of the value of
the project.
Considering the cash flow rate of 6%2, the return of the project is as
follows:
– either 30% + 6% = 36%;
– or −30% + 6% = −24%.
By retaining a risk-free rate of 2%, the probability of risk-neutral p can be

calculated:
36%. p − 24%. 1 − p = 2% and ≈ 43.3%
Consequently, the value of the option is as follows:
43.3% × 6,500 − 3,600 + 56.7% × 3,500 − 3,600

1 + 6%
2 That is, 300/5,000.

= €1,132.08 million
If the company invests immediately, it waives this optional value which

represents an opportunity cost of €1,132.08 million.
The overall cost price is therefore 3,600 + 1,132.08 = €4,732.08 million,

and the adjusted net present value (ANPV) is 5,000 − 4,732.08 = €267.92
million. The project can be realized.
3.2.2. Application of the Dixit and Pindyck model
It is assumed that an investor wishes to subscribe to a call option of a

share of a company with infinite maturity at an exercise price equal to the
current stock price, i.e. €100. On the day of the valuation, we admit that the
price is liquid enough to constantly reflect the analysts’ consensus. The
valuations they realize are supposed to come from the DCF approach. To
carry out a valuation using the options method, the following assumptions
are used:
– the 10-year Treasury bill rate is 2%;
– the market risk premium is 4%;
– the beta of the company is 1.2;
– the last dividend paid is €5;
– the volatility of the annualized share is 25%.
It is then possible to determine the expected return of the share μ from

the Capital Asset Allocation Model (CAPM) based on the Sharpe model
(1964):
μ = 2% + 1.2 × 4% = 6.8%
The dividend rate δ is:
5
δ= = 5%
100
Data Generation 111
The rate of appreciation α, which corresponds to the difference between

the rate of return and the dividend rate, is:
α = 6.8% − 5% = 1.8%
In order for the option to be exercised, the stock price must reflect a new
value, obtained by the DCF method, which is called V*. According to the
Dixit and Pindyck model, we have:
β
V∗ = .I
β −1
where:
1
− r−δ− σ + √Δ
β = 2
σ
with:
1
Δ= r−δ− σ + 2. r. σ
2
1
Δ = 2% − 5 − × 25% + 2 × 2% × 25% = 0.006
2
and:
1
− 2% − 5% − × 25% + √0.006
β = 2 = 2.25
25%
Thus:
2.25
V∗ = . I = 1.803 2. I
2.25 − 1
The exercise price of the option is represented by I. As a result, the call
option with infinite maturity will have to be exercised when the value of the
underlying derived from the DCF method (reflecting the stock price) will be
1.8 times higher than the current price. Here, I = €100, which means that the
call option will be exercised when the stock price reaches the value of
€180.32.
The premium F of the option is then:
V∗ − I
F = A. V and A =
V∗
Then:
180.32 − 100
A= = 0.001.
180.32 .
and:
.
F = 0.001 × 100 = 21.38
Since the option is on the valuation day at the money3, the intrinsic value
is 0. Thus, the option premium exclusively consists of the time value. A
sensitivity analysis on the value of the option can then be constructed. The
latter is based on the value of the underlying and the volatility.
Volatility Price of the underlying (in €)

100 110 120 130 140 150 160 170 180 190 200
25% 21.38 25.44 29.76 34.32 39.10 44.09 49.27 54.62 60.14 65.82 71.64
26% 22.49 26.71 31.19 35.90 40.83 45.97 51.29 56.79 62.46 68.28 74.23
27% 23.59 27.96 32.59 37.46 42.54 47.82 53.29 58.93 64.73 70.69 76.78
28% 24.69 29.21 33.98 38.99 44.22 49.64 55.25 61.03 66.97 73.05 79.27
29% 25.78 30.44 35.36 40.51 45.87 51.44 57.18 63.09 69.15 75.36 81.71
30% 26.85 31.66 36.72 42.00 47.50 53.20 59.07 65.11 71.30 77.63 84.10
V-I 0 10 20 30 40 50 60 70 80 90 100
Table 3.1. Sensitivity of the premium of an option to the

value of the underlying and the volatility
3 The exercise price I is equal to the value V obtained using the DCF.
Data Generation 113
3.3. Flexibility of asset exchange, abandonment and temporary

shutdown of projects
Margrabe’s (1978) model of valuing a project with an exchange option is

modeled after Black and Scholes by replacing the price of the underlying
with the price relationship of two interchangeable assets.
In addition, the abandonment option is similar to a put option to the

extent that the company plans to make a risky investment by anticipating the
eventual resale of the project if an adverse external event, such as a less
advantageous regulation, occurs.
Finally, when calculating the value of an investment project, the

temporary shutdown option makes it possible to take into account any
interruptions in the operation of a machine or a concession during a given
period. This implies knowing the volatility of the market price of the
marketed product. Depending on the state of the market, the company can
choose, over a period of time, to continue or stop the operation. The option
value resulting from this operational flexibility finds its essence in the fact
that the operation is launched or interrupted, on the date of decision,
provided that the selling price of the product is, respectively, higher or lower
than its cost price.
3.3.1. Application to the exchange option
Assuming that a company is considering a project to operate a production

system consisting of turning an asset 2 into an asset 1:
– asset 2 has a value of €200 and asset 1 has a value of €400;
– the volatility of asset 2 is 25% and that of asset 1 is 35%;
– the correlation coefficient is 45%;
– the production system must operate for 10 years and be implemented
annually if the operation is profitable by observing the beginning exercise
price, i.e. if the price of asset 1 is higher than that of asset 2.
Under such conditions, the company has an option to exchange asset 2 for
asset 1. This option must, at the beginning of these considerations, be
exercised. The intrinsic value is then 200. The value of the option can then
be calculated using Margrabe’s formula (1978). The latter replaces, in the

Black and Scholes formula, the price of the underlying (here asset 2) by the
ratio between the price of asset 1 and that of asset 2 and the volatility of the
underlying by the variable relating assets 1 and 2. According to Margrabe,
the risk-free rate is zero, because the company is supposed to intervene on a
market at equilibrium. The volatility of the combined variable of the two
assets is as follows:
σ = σ +σ − 2ρ. σ .σ
σ = 25%² + 35%² − 2 × 40% × 25% × 35% = 33%
The value of the project is then equal to the sum of the 10 call
options with maturities ranging from 0 to 9 years. Table 3.2 summarizes
the value of these options by showing, in addition to the total values
obtained from Margrabe’s formula (1978), the values of d1, d2, F(d1) and
F(d2), where F represents the distribution function of the standard normal
distribution.
Maturity d1 d2 F(d1) F(d2) Value of the option

0 200
1 2.29 1.96 0.99 0.98 200.55
2 1.73 1.27 0.96 0.90 203.72
3 1.51 0.95 0.93 0.83 208.24
4 1.39 0.74 0.92 0.77 213.14
5 1.32 0.59 0.91 0.72 218.08
6 1.27 0.47 0.90 0.68 222.91
7 1.23 0.37 0.89 0.65 227.58
8 1.21 0.29 0.89 0.61 232.08
9 1.20 0.22 0.88 0.59 236.39
_________
2,162.68
Table 3.2. Value of an investment project with an exchange

option according to Margrabe’s formula (1978)
Data Generation 115
3.3.2. Application to the abandonment option
Assuming that a company wishes to make an investment worth €3,600

million, the investment should generate each year:
– either with a probability of 50%, annual cash flows of €390 million;
– or with a probability of 50%, annual cash flows of €120 million.
This difference in flow comes from the fact that the company is waiting
for a call for bids in which it has just participated. In the case of resale of the
initial investment (if the company does not win the call for bids), it would
recover €3,300 million. In addition, a discount rate of 6% and a risk-free rate
of 2% are used.
Then, the value of the project in t = 1 will be:
– either:
390
6%
– or:
120
6 %
The expected value is therefore:
50% × 6,500 + 50% × 2,000 = €4,250,000
In this context, the project holds:

– a capital gain of: 6,500–3,600 = €2,900 million or 81% of the value of
the project;
– a capital loss of: 3,600–2,000 = €1,500 million or −44% of the value of
the project.
Considering the cash flow rate of 6%, the return of the project is as
follows:
– either 81% + 6% = 87%;
– or −44% + 6% = −38%.
By retaining a risk-free rate of 2%, the probability of risk-neutral p can be

calculated:
87%. p − 38%. 1 − p = 2% ≈ 32%
Consequently, the value of the option is as follows:

%× , , %× , ,
32 = − €136 million
%
3.3.3. Application to the temporary shutdown option
The investment project is similar to a portfolio of n calls (where n

represents the number of dates during which the company decides whether
or not to continue operating). The options then have the following
characteristics:
– value of the underlying asset: cash sales price of the manufactured
product;
– exercise price: production cost;
– maturity date: date of decision to pursue or shut down the operation.
Assuming that a company is thinking of responding to a call for bids on

the operation of a raw material concession for a period of 10 years, the
market price of the resource is currently €30 per unit extracted which can be
resold. Its cost price is €22, and the volatility of its market price is estimated
at 35%. The annual production capacity is 500,000 units. The continuous
risk-free rate is 2%, and it is assumed that start-up or shutdown costs are
negligible.
First application: the company can make the decision to stop the
operation once a year. Thus, the project is similar to a portfolio of 10 options
with an exercise price of €22 and a price of the underlying asset of €30. In
this context, the first option must be exercised immediately. As it has no
time value, its premium is equal to its intrinsic value, i.e. €8 per unit
extracted, which is €4 million for the entire production of the year. The other
nine options are valued by the Black and Scholes (1973) formula.
Data Generation 117
The value of the project is the sum of the 10 options. The details of the
calculation are given in Table 3.3.
Rank of the
0 1 2 3 4 5 6 7 8 9
option
S0 30 30 30 30 30 30 30 30 30 30
E 22 22 22 22 22 22 22 22 22 22
σ 35% 35% 35% 35% 35% 35% 35% 35% 35% 35%
Continuous
2% 2% 2% 2% 2% 2% 2% 2% 2% 2%
r
Valuation 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/
date 2016 2016 2016 2016 2016 2016 2016 2016 2016 2016
Maturity 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/ 1/1/
date 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025
τ 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00
d1 1.12 0.95 0.91 0.91 0.92 0.93 0.95 0.97 0.99
d2 0.77 0.46 0.31 0.21 0.13 0.07 0.02 −0.02 −0.06
F(d1) 0.8683 0.8302 0.8196 0.8179 0.8200 0.8239 0.8287 0.8340 0.8394
F(d2) 0.7788 0.6772 0.6208 0.5821 0.5528 0.5291 0.5092 0.4920 0.4768
Value of
the call
option per 8.00 9.25 10.59 11.73 12.71 13.60 14.39 15.12 15.79 16.42
unit
produced
Sum of call
option 127.61
values
Installed 500,000
capacity /year
Production
over the
5,000,
entire
000
period
(10 years)
Value of
the
concession 638.045
(in million
€)
Table 3.3. Valuation of a temporary shutdown option

(possibility of exercise once a year for 10 years)
Rank of the
option 0 1 2 3 4
S0 30 30 30 30 30
E 22 22 22 22 22
σ 35% 35% 35% 35% 35%
Continuous r 2.0% 2.0% 2.0% 2.0% 2.0%
Valuation date 01/01/2016 01/01/2016 01/01/2016 01/01/2016 01/01/2016
Maturity date 01/01/2016 01/01/2018 01/01/2020 01/01/2021 01/01/2023
τ 0.00 2.00 4.00 6.00 8.00
d1 0.95 0.91 0.93 0.97
d2 0.46 0.21 0.07 −0.02
F(d1) 0.8302 0.8179 0.8239 0.8340
F(d2) 0.6772 0.5821 0.5291 0.4920
Value of the
call option per
unit produced 8.00 10.59 12.71 14.39 15.79
Sum of call
option values 61.49
Installed
capacity 500,000/year
Production
over the entire
period (10
years) 5,000,000
Value of the
concession (in
million €) 307.467
Table 3.4. Valuation of a temporary shutdown option (possibility of

exercise once every 2 years for 10 years)
Second application: the option is exercisable every 2 years (5 times in

total during 10 years).
Data Generation 119
Third application: the option can be exercised every 5 years, i.e. twice in
total for a period of 10 years.
σ 35% 35%
continuous r 2.0% 2.0%
valuation date 01/01/2016 01/01/2016
maturity date 01/01/2016 01/01/2018
τ 0.00 2.00
d1 0.95
d2 0.46
F(d1) 0.8302
F(d2) 0.6772
Value of the call option per
8.00 10.59
unit produced
Sum of call option values 61.49
Installed capacity 500,000/year
Production over the entire

5,000,000
period (10 years)
Value of the concession

307.467
(in million €)
€30,746,710.53
Table 3.5. Valuation of a temporary shutdown option (possibility

of exercise once every 5 years for 10 years)
Consequently, the lower the flexibility, the lower the value of the option.
In absolute terms, if the option is exercised only once every 10 years, the
value of the project corresponds to its intrinsic value, i.e. €8 per unit. In fact,
in this case, it is exercised immediately and has no time value. Thus, a
concession whose production capacity is 500,000 units per year, or 5 million
units produced over 10 years, will have a value of €40 million.
Value of the investment project 700

600
500
(in million €)
400
300
200
100
0
1 2 5 10
Number of exercise dates of call opons
Figure 3.2. Sensitivity of the value of an investment project composed

of call options with the number of call exercise dates
In addition, the value of the project is higher as the price volatility of the
underlying is also higher. This is justified by the fact that the vega of the
calls is positive.
1,000
Value of the project (in million €)
800
Value of the project
600 with 2duexercise
Valeur dates2
projet avec
dates d'exercice
400 Valeur
with 5duexercise
projet avec
dates5
dates d'exercice
Valeur du projet avec 10
200 withd'exercice
10 exercise
dates
dates
0
1% 15% 25% 35% 45% 55% 65% 75% 85% 95%
Volality
Figure 3.3. Sensitivity of the value of the project to the volatility of the underlying
Data Generation 121
3.4. Incorporation of development phases
An option to carry out the second phase of an investment project is

equivalent for a company to commit funds of a relatively small amount
initially. This allows it to test its market in order to know if it is appropriate
to make a second, more significant, investment. The latter, intervening at the
end of the first period, may depend on factors such as deregulation or a
reduction in operating costs.
In addition, the uncertainty relating to each investment project leads us to

consider the notion of risk during their analysis, especially if they are of a
sequenced nature, i.e. each phase depends on the success or failure of the
preceding one. In the event of failure, the capital invested until then is
definitively lost, but the decision to stop the project makes it possible to
avoid depreciating it further. In this context, the consideration of market
uncertainty, i.e. market acceptance of the proposed product or service,
depends on the ability of the latter to meet consumer expectations.
3.4.1. Implementation of a two-stage investment project
Assuming that a company plans a first investment project such as the

acquisition of an asset, i.e. a machine, it also considers the possibility of
investing in a second project, provided that at the end of the economic and
fiscal life of this machine, the market is deregulated. The characteristics of
the two projects are presented in Table 3.6.
The NPV of the first project is:
1 − 1 + 6%
− 3,600 + 390. = − €1,682,000
6%
In addition, it turns out that as the cash flows generated by the second
investment project (if realized) are €12,000 million at the date of completion
of this second phase; the current value of the underlying at the time of the
valuation, namely, today, is as follows:
12,000
= €8,459.5 million
1 + 6%
First investment phase

Investment 3,600
Annual cash flow 390
Maturity of the project 6 years
Retained discount rate 6%
Second investment phase
Investment 20,000
Discounted future cash flows 12,000
Investment implementation horizon 6 years
Volatility of the shares of the business sector 25%
Risk-free rate 2%
Table 3.6. Characteristics of two related investment projects (amounts in million €)
In this context, the option can be valued according to the Black and
Scholes formula:
8,459.5 25%
+ 2% + .6
20,000 2
d = = −0.90
25 % × √6
d = −0.9 − 25% × √6 = −1.51
Therefore:
%×
C = 8,459.5 × Φ −0.90 − 20,000 × e × Φ −1.51
= 400 million €
By adding the NPV of project 1 and the value of the option of project 2,
we note that the project must be abandoned:
− 1,682 + 400 = − 1,282 million €
3.4.2. Valuation of a sequential project
The probability of success or failure of a project can be defined in a

risk-neutral framework, as thought by the Black and Scholes model (1973)
Data Generation 123
or the Cox, Ross and Rubinstein model (1979). On the other hand,
uncertainty may be closely related to the actual events, that is to say, to the
possible successes or failures relative to the realization of a real innovation,
the regulation of which will authorize the commercialization of the product
or the service. This is for managers to determine a more or less optimistic
subjective probability about the chances of success or failure of the
corresponding event. The determination of this probability is based on the
experience and knowledge of the executives.
Assuming that Sysrev’s business consists of designing flight reservation

management systems for airlines (flight reservation, addition of services,
change of flights and cancellation of reservation), a project to market their
new system interests three companies. The investment includes a server,
reservation systems, the cost of the installation and the operating license.
Sysrev begins by analyzing the needs of its potential customers, and then the
company defines the price structure of its systems. In fact, the invoices will
be established based on a simple matrix, according to a fixed price for each
system type.
After carrying out a market study, Sysrev prepares its initial prices and
provides the traffic structure of the type of actions performed on each of the
reservations (simple reservation, addition of services, change of flight,
cancellation of reservation). The company also expects to lower prices by
10% per year starting in the second year to encourage demand and to
eliminate the entry of competition into this market.
Type Rate Weighting

Service 1: standard reservation 0.5 45%
Service 2: adding of service 1 25%
Service 3: change 1.5 20%
Service 4: cancellation 2 10%
Table 3.7. Rates according to possible actions in €
Year 1 2 3 4 5
Traffic 5 7 14 19 21
Table 3.8. Traffic forecast (in millions of possible actions)

The investment expenditure is as follows:

– Server: €12,000,000.
– Reservation system, or RS (€5,000,000 each):
- a first system is proposed by Sysrev the first year (year 0): it is a
reservation system for the travel agents of the airlines;
- an additional reservation system is proposed in the second year (year
1): it is a B2C e-commerce solution, namely, a reservation system available
directly on the company’s website;
- an additional reservation system in the third year (year 2): this is a
system for offering rental cars and hotels.
– The cost of installing, programming and configuring the server:

€1,000,000.
– The cost of the license for a period of 5 years (€1,500,000).
Investments are amortized on a straight-line basis over the remaining life

of the project, as there is no second-hand market for this type of service. The
residual value is thus zero.
Commercial and general operating costs break down as follows:

– maintenance costs: €7,000;
– personnel expenses: €4,000 per month;
– billing fees: 0.3% of gross income;
– overhead costs: €3,000,000 plus 2% of gross income;
– commissions on sales: 8% of gross income.
In addition, the following information is available:

– the average tax rate on profits: 40%;
– the risk-free rate: 2%;
– the cost of the pre-tax debt: 4%;
– the cost of equity: 15%;
– the financing of the company: 35% per debt.
Data Generation 125
To begin, it is necessary to calculate an average price per possible action,

i.e. according to the services offered. Prices and consumption patterns are
assumed to be stable over the 5 years.
Type Weighting Price/minute Adjusted price/action

Service 1 45% 0.5 0.225
Service 2 25% 1 0.25
Service 3 20% 1.5 0.3
Service 4 10% 2 0.2
Average price/action – – 0.975
Table 3.9. Calculation of price/possible action
The turnover is obtained by multiplying the traffic (volume in millions of

actions) by the average price per action. The latter is supposed to fall by 10%
per year from the second year.
Year 1 2 3 4 5
Traffic (in millions of
5 7 14 19 21
actions)
Price 0.975 0.88 0.79 0.71 0.64
Turnover (in million €) 4.875 6.14 11.06 13.50 13.43
Table 3.10. Turnover (in millions) of the Sysrev project
20 14
12
15 10
8
10
6
5 4
2
0 0
1 2 3 4 5
Year
Traﬃc (in millions of acons) Turnover (in million €)
Figure 3.4. Evolution of traffic and turnover

The “S” shape of the traffic curve is specific to the externalities of the
service sector. According to Goolsbee and Klenow (2006), at the launch of
an Internet project of this type, the users gradually increase until reaching a
point of inflection synonymous with greater growth. After having reached its
peak, the rate of use then slows down or even decreases when the market is
saturated, because of the adoption of the innovation. As a result, in year 5,
the continuous decline in prices (10% per year) to counter competition and
encourage new users to enter the market is such that the turnover declines
despite the positive (lower) trend of the traffic.
We then guess the difficulty of evaluating this type of risky investment

project, with network effects, with conventional methods such as the NPV,
insofar as the forecasts of the users and, beyond, the sales prove to be a
delicate exercise. In fact, the success of the project depends on achieving a
critical mass of users that must generate not only positive cash flows but also
sufficient profitability.
Investment expenditure is made from the beginning (year 0) and for the
first 3 years.
Year 0 1 2
Server 12,000 0 0
RS 5,000 5,000 5,000
License 1,500 0 0
Installation 1,000 0 0
Total investments 19,500 5,000 5,000
Table 3.11. Investment expenditure in K €
Depreciation is linear and carried out over the remaining life of the
project, assuming that as this market is very specific, it is impossible to sell
the investments over time.
Year 1 2 3 4 5
I1 3,900 3,900 3,900 3,900 3,900
I2 0 1,250 1,250 1,250 1,250
I3 0 0 1,667 1,667 1,667
Total depreciation 3,900 5,150 6,817 6,817 6,817
Table 3.12. Depreciation in K €

Data Generation 127
Table 3.13 summarizes the forecasts of operational costs.
Year 1 2 3 4 5
Number of RS 1 2 3 3 3
Maintenance cost 7 14 21 21 21
Personnel expenses 48 48 48 48 48
Total OPEX 55 62 69 69 69
Table 3.13. Operational costs in K €
In this context, it is possible to create a projected income statement. The

latter shows that the operating result is negative the first 2 years, when the
company reaches a critical threshold of users. Between the third and fourth
years, REX increases significantly before falling back to year 5, due to lower
prices.
Year 1 2 3 4 5
Turnover 4.875 6.143 11.057 13.505 13.434
OPEX 55 62 69 69 69
Depreciation 3.900 5.150 6.817 6.817 6.817
Operating income 920 931 4.171 6.619 6.548
Operating margin 18.9% 15.1% 37.7% 49.0% 48.7%
Commercial costs 390 491 885 1,080 1,075
Billing costs 15 18 33 41 40
General and
3.098 3.123 3.221 3.270 3.269
administrative costs
Subtotal 3.502 3.633 4.139 4.391 4.384
REX −2.582 −2.702 32 2.228 2.164
Operating margin −53.0% −44.0% 0.3% 16.5% 16.1%
Table 3.14. Income statement in K €
In the first 4 years, the company would not pay a corporate tax, because
of the carry forward of the previous deficits accumulated during the first
years of the project. The postponement also improves the profitability of the
company, because it pays a very low tax in year 5, for a much higher
operating result.
Year 1 2 3 4 5
Tax base −2.582 −5.284 −5.252 −3.024 −860
Corporate tax 0 0 0 0 −344
EBIAT −2.582 −2.702 32 2.228 2.508
EBIAT margin −53% −44% 0% 16% 19%
Table 3.15. Taxation in K €4
In order to carry out the business plan and calculate the NPV of the
project, it is necessary to calculate, beforehand, according to the information
available, the weighted average cost of the capital of the company.
Cost of debt (before tax) 5.0%

Cost of debt (after tax) 3.0%
Cost of CP 15.0%
% of debt 35.0%
% of CP 65.0%
WACC 10.8%
Table 3.16. WACC calculation
where WACC: K = kCP + kD , with:
– kD: the rate of return required by the creditors after tax;

– kCP: the rate of return required by the shareholders (previously, Ri);
– VD: the market value of net indebtedness;
– VCP: the market value of equity.
In order for the above calculation to be relevant, that is to say, so that the
assumed risk is the result of weighting the debt burden and the equity taking
4 EBIAT: Earning Before Interest After Taxes, or the result before taking into account the
interest, but after taking into account the tax.
Data Generation 129
into account their cost, it is necessary to specify that the project must be of
such a nature to carry the same economic risk as that of the company as a
whole. In concrete terms, this means that the investment project is closely
linked to the major business sector of the company, that the GOS is more or
less constant and that the project is financed in the same proportions as the
overall level of indebtedness of the company.
Year 0 1 2 3 4 5
EBIAT 0 −2.582 −2.702 32 2.228 2.508
Depreciation 0 3.900 5.150 6.817 6.817 6.817
Cash flows 0 1.318 2.448 6.849 9.045 9.325
Discounted cash
0 1.189 1.994 5.035 6.001 5.584
flows
Investment −19.500 −5.000 −5.000 0 0 0
Discounted
−19.500 −4.902 −4.806 0 0 0
investment
Discounted free
−19.500 −3.713 −2.812 5.035 6.001 5.584
cash flows
Discounted
−19.500 −23.213 −26.025 −20.990 −14.988 −9.404
cumulative FCF
Discounted cash
19.803
flows
Discounted
−29.208
investment
NPV −9.404
Table 3.17. Business plan and calculation of the NPV of the project in K €
The discounted free cash flow at the WACC is the result of EBIAT
reprocessing, which has been increased by amortization charges
(non-disbursable expenses), reduced investments (expenses not taken into
account in the income statement) and discounted at the risk-free rate. In fact,
according to Luehrman’s work (1998), it is assumed that the company,
which defers certain investment expenditures, places its funds at the risk-free
interest rate. We note that the NPV is negative. Consequently, according to
this valuation criterion, the project must be abandoned.
However, Sysrev wants to incorporate flexibility by incorporating

possible additional development phases. In fact, in 3 years, the company
would have, by its positioning on the market, exploitable information. In
other words, the company plans to make an additional investment to set up
passenger data services (frequent flyer management) to offer personalized
solutions to travelers. Moreover, in 5 years, Sysrev sees the possibility of
developing solution services (management of taxis, hotels, etc.) in
connection with impromptu events such as natural disasters (volcano
eruptions, etc.). The second project would require an additional investment
expenditure of €90 million and would generate €80 million in cash.
Similarly, the third project would require an additional investment
expenditure of €150 million and would generate €125 million in cash.
Data in million € Inv. Dis. inv. in 0 Dis. CF in 0 NPV

First phase −29.21 −29.21 19.803 −9.404
Second phase in 3 years −90 −84.81 80 −4.809
Third phase in 5 years −150 −135.86 125 −10.860
Total −269.21 −249.88 224.80 −25.07
Table 3.18. Incorporation of two other development

phases in the investment project in K €
The term “Dis. inv.” means that, as before, the investment is discounted
at the risk-free rate. The two additional projects envisaged have a negative
NPV, leading to an amplification of the idea of abandoning the project.
However, as it stands, the valuation of these projects does not take into
account the potential for flexibility. In fact, if the state of the market is
unfavorable for the company in 3 years, then in 5 years, it is reasonable to
think that it will not undertake to make such investments. It is then a
question of considering two composite growth options insofar as the third
project will be realized only if the second one is a success. The maturities
are, respectively, 3 and 5 years. We thus find the idea of the ANPV, which
consists of adding to the NPV of the first project the value of the call
composed of the second and third projects, according to the Cox, Ross and
Rubinstein binomial model (1979).
Data Generation 131
Second
Variable Description phase Third phase
S Current value of cash flows 80 125
T Life of the option (in years) 3 5
s Standard deviation of cash flow (volatility) 45% 45%
r Risk-free rate 2% 2%
Nb per Number of periods 3 5
t Nb of years/Nb of periods 1 1
r' Adjusted risk-free rate (1+r)^t 1.02 1.02
up Exp(s × t^0.5) 1.5683 1.5683
down 1/up 0.6376 0.6376
Pu (r'-down)/(up-down) 0.4109 0.4109
Pd 1-Pu 0.5891 0.5891
Table 3.19. Characteristics of the investment project according

to the Cox, Ross and Rubinstein binomial model
0 1 2 3
0 80 125.46 196.77 308.59
1 51.01 80 125.46
2 32.53 51.01
3 20.74
Table 3.20. Evolution of the cash flows of the second phase of the project in K €
0 1 2 3 4 5
0 125 196.04 307.45 482.18 756.21 1,185.97
1 79.70 125 196.04 307.45 482.18
2 50.82 79.70 125.00 196.04
3 32.41 50.82 79.70
4 20.66 32.41
5 13.17
Table 3.21. Evolution of the cash flows of the third phase of the project in K €
In order to obtain the value of the option of the third phase, for example,
it is necessary to start by calculating the terminal value in year 5, namely,
the final payment, which corresponds to the maximum between 0 and the
cash flows of the fifth year reduced by the exercise price. Thus, for year 5,
line 0: Max (1,185.97-150; 0) = 1,035.97.
Then, the tree must be reassembled in reverse order towards year 0. By

reasoning in a risk-neutral context, it is then necessary to calculate the value
at each node as the discounted expectation of the two possible values of the
option. Thus, for year 4, line 0, the value of the option is:
609.15 × 0.4109 + 160.39 × 0.5891

C . = = 338.00
1.02
Call 0 1 2 3 4 5
0 46.27 92.38 179.65 338.00 609.15 1,035.97
1 15.70 34.65 75.32 160.39 332.18
2 3.01 7.47 18.54 46.04
3 0.00 0.00 0.00
4 0.00 0.00
5 0.00
Table 3.22. Value of the option of the third phase of the project in K €
Call 0 1 2 3
0 24.26 51.97 108.53 218.59
1 5.75 14.29 35.46
2 0.00 0.00
3 0.00
Table 3.23. Value of the option of the second phase of the project in K €
In order to valuate the composite option, it is necessary to rely on the

binomial tree of the growth option of the third phase. Years 4 and 5 are
reported without modification. In addition, for year 3, the payment of the
option includes the second phase of the project and the discounting of cash
flows corresponding to the third phase, considering that the second phase
Data Generation 133
was undertaken. Indeed, if the project is stopped at the end of the second
phase, it no longer generates any cash flow thereafter (years 4 and 5). In this
context, for example, for year 3, line 0, the value of the composite option is:
C .
308.59 − 90 + 609.15 × 0.4109 + 160.39 × 0.5891
= MAX ;0
1.02
= 556.60
Call 0 1 2 3 4 5
0 67.52 141.85 288.18 556.60 609.15 1,035.97
1 17.97 44.62 110.78 160.39 332.18
2 0.00 0.00 18.54 46.04
3 0.00 0.00 0.00
4 0.00 0.00
5 0.00
Table 3.24. Value of the composite option of the

second and third phases of the project in K €
The composite option thus has a value of €67.52 million and makes it
possible to consider that the project must be undertaken, insofar as, by
integrating managerial flexibility, the ANPV of the investment is positive up
to €58 million. The additional phases in 3 and 5 years will then be conducted
taking into account the state of the market.
NPV 1 −9.404
Composite option 67.52
ANPV 58.114
Table 3.25. Overall value of the project in K €

Conclusion
The traditional calculation of the net present value (NPV) makes it

possible to know if, considering the characteristics of a project, the company
must invest immediately or never. However, when it has exclusive rights to a
project for a given period, it may decide to delay it and realize it at a later
date at its convenience. Thus, the question of investing is not simple. Beyond
the fact of abandoning the investment, it is a question of knowing if it is
necessary to provide for it immediately or to reject it. As a financial decision
support tool for investment in low-visibility contexts, the real option applies
to an underlying non-financial asset taking into account all the possibilities
of the project. The process consists of discerning, step by step, market
growth opportunities while limiting downside risks. The reasoning differs
from traditional analyses insofar as active management is advocated on all
continuous future flows.
Managerial flexibility favors changes or optimization of operations

according to newly available information. The tool provides a broader
picture of the project than a traditional financial valuation. Finally, there is
no discount rate assumption and the risk by taking into account volatility is
modeled, since, in case of a wrong trajectory, the project can be abandoned.
Two approaches to estimating risk can be used. The first, based on a market
vision, is based on the volatility of the share of the company holding the
project, on the implied volatility of the option on the security or on
stochastic volatility. The second, focused on the project itself, estimates its
own volatility using a simulation of the distribution of values by the Monte
Carlo method. The standard deviation obtained is used as an estimator of
volatility.

Different types of real options exist: those that value investment projects
(growth option, abandonment option, carry option), those that value the
production process (option of temporary cessation of production, choice of
inputs, outputs), those that value the flexibility of fixed capital, etc. These
may be call options (strategic investment, merger, acquisition, etc.) or put
options (transmission, split, etc.). The valuation parameters are similar to
those of the financial options modeled in continuous time by Black and
Scholes (1973) and in discrete time by Cox et al. (1979). Volatility
represents the level of project uncertainty measured by the dispersion of the
project value. The latter is the current value of the probable cash flows. The
exercise price is equal to the amount to be invested. The maturity of the
option is the life of the project, and the risk-free rate depends on the level of
solvency of the issuer. Models can also include project costs (such as
transaction or production costs), dividend payments, or the revenue
generated by the project. Thus, the real option appreciates as the price of the
underlying is large, volatile and not subject to dividends. A low exercise
price, high interest rates and a long expiration period also contribute to its
valuation. The flexibility of adaptation increases the chances of success and
limits the risk of loss.
Absent from traditional valuation techniques and yet valuable, time gives
decision-makers the opportunity to make new decisions or postpone them;
flexibility makes it possible to respond or react to new information by
changing the organization of a project. In addition, traditional methods,
based on discounting, penalize risky projects, since the value decreases with
risk (the discount rate includes a risk premium). The DCF method may lead
to the rejection of a project with a high investment, low cash flows, but
possibly future growth opportunities. On the other hand, the value of a
project estimated by the real options is all the greater as the uncertainty and
the time remaining before the end of the opportunity are considerable. Thus,
the real options approach makes it possible to value a company’s investment
project.
If companies tend to wait before investing to gather more information

about the market in general, they have the opportunity to combine different
categories of options to better understand their investment project by giving
them more flexibility and by framing even more precisely the notion of risk.
In addition, the real options go beyond the scope of internal growth projects.
In fact, they find their place on the control market insofar as the acquisition
strategies can integrate growth options, beyond the considerations of
Conclusion 137
influence and remuneration of the executives developed in Chapter 1. In fact,

synergies can take place in the implementation of growth options. The
offerer who owns the resources may, after having redeemed its target
holding growth options impossible to implement due to lack of sufficient
means, make them available to its target.
In this context, it is conceivable to consider that the real options approach

can directly evaluate the liability structure – and no longer only the value of
an asset – and thus be complementary to traditional valuation methods, such
as that of DCFs or multiple stocks. In fact, the intrinsic value of equity is
usually the result of valuation via the DCF approach. In addition, the net
debt that forms part of the cost of capital calculation (which serves as a
discount rate) is the amount present in the company’s reference documents.
But the net debt, which is subsequently deducted from the enterprise value
obtained in order to obtain equity, should also be based on an economic
value.
Appendices

Appendix 1
Demonstration of the CRR Formula
The Cox, Ross and Rubinstein (1979) option valuation model is based on
the assumption that the value of the underlying asset follows a discrete-time
multiplicative binomial law. The stock price may, in each period, either
increase and go to uS at the end of the first period, or decrease and go to dS
with the respective probabilities q and 1−q. Thus, the rate of return of the
share in each period is either u−1 with the probability q, or d−1 with the
probability 1−q. If the value of the asset increases (or decreases), the call
premium also increases (or decreases) with the probability q (or with the
probability 1−q).
Maturity dates correspond to periods. At t = 1, the value of the call

corresponds to its payment. We then have:
Cu = max(0,uS - E) and Cd = max(0,dS - E) [A1.1]
Based on the constitution of a hedging portfolio P consisting of the

purchase of a call of which the premium is C and the sale of H shares:
P = HS – C [A1.2]
Since P is a hedging portfolio, it is risk-free. Thus, its return corresponds

to the risk-free rate r and its value, at each period (i.e. when t = 1), is unique:
HS − C = = [A1.3]
Then:
HuS − C = HdS − C and HS = [A1.4]
Note: ̂ = 1 + . Thus:
HuS − C
HS − C =
1+r
and:
HuS − C 1
C = HS − = rHS − uHS + C
̂ r
1 C −C C −C u−d
= r −u + C
r u−d u−d u−d
= C + C [A1.5]
Suppose:
̂
p= ; then 1 − p = 1 − = = [A1.6]
C= pC + 1 − p C [A1.7]
The probability q does not appear in the formula. This means that even
though different investors have different subjective probabilities about an
upward or downward movement of the share, they might agree on the
relationship of C with S, u, d and r.
C does not depend on the attitude of investors according to their

respective risk. The formula would be the same, regardless of the investors’
risk aversion. So, if investors are in a risk-neutral environment, the required
rate of return of the share is the risk-free rate, so:
quS + 1 − q dS = rS and q = =p [A1.8]

Appendix 1 143
If the expiry date corresponds to two periods:
u2S Cuu
uS Cu
S udS Cuu
C
dS
Cd
d2S Cdd
t=0 t=1 t=2 t=0 t=1 t=2
At t = 1, the value of P is:
HuS − C = = [A1.9]
Hu S − C = HudS − C [A1.10]
HuS = [A1.11]
HuS − C = [A1.12]
Hu S − C
C = HuS −
r
1
= rHuS − Hu S + C
r
1 C −C C −C u−d
= r −u + C
r u−d u−d u−d
1 r−d u−r
= C + C
r u−d u−d
= pC + 1 − p C [A1.13]
In the same way:
Hds − C = = [A1.14]
Huds − C = Hd S − C [A1.15]
Hds = [A1.16]
HudS − C 1
C = HdS − = rHdS − HudS + C
r r
1 −C
C C −C u−d
= r −u + C
r u−d u−d u−d
1 r−d u−r
= C + C
r u−d u−d
= pC + 1 − p C [A1.17]
If Cu and Cd are, respectively, replaced by [A1.14] and [A1.18] in [A1.7]:
1 1 1
C= p pC + 1 − p C 1−p pC + 1 − p C
r r r
1
= p C +p 1−p C +p 1−p C +p 1−p C
r
+ 1−p C
= p C + 2p 1 − p C + 1 − p C [A1.18]
If the maturity date is t = 2, the premium at t = 2 corresponds to the

payment of the call:
1
C= p . max 0, u S − E + 2p 1 − p . max 0, udS − E
r
+ 1 − p . max 0, d S − E
C= ∑ Cn p 1 − p . max O, u d S−E [A1.19]
If the maturity date is n periods. Suppose X is the random variable

corresponding to the number of upward movements of the share after n
periods. X is the binomial variable with n and p parameters:
X  B(n, p) P[X = k] = Cnk pk(1−p)n−k. Suppose that a represents the
minimum number of upward movements that the share must perform after n
periods so that the call ends in the money. Then:
PX≥a = C p 1−p =P X=a +P X=a+1
+⋯+ P X = n [A1.20]
Appendix 1 145
Moreover, the value of C given in [A1.20] can be split into two terms:
1
C= C p 1−p . max 0, u d S−E
r
[A1.21]
1
+ C p 1−p . max 0, u d S−E
r
If 0 < k < a, the call is out of the money and its payment is zero:
max(0,ukd n−k S – E) = 0. In addition: max(0, ukd n−k S – E) = ukd n−k S – E. Et:
C= ∑ C p 1−p u d S−E [A1.22]
C= ∑ C p 1−p u d S − Er ∑ C p 1−p [A1.23]
C = S ∑ C − Er ∑ C p 1−p [A1.24]
Suppose: p = .
Thus: 1 − p = 1 − p=1− .
r u−d −u r−d
=
r u−d
= = 1−p [A1.25]
C = S∑ C p 1−p − Er ∑ C p 1−p [A1.26]
Let F(a, n, p) be the complementary binomial distribution function:
C = SF a, n, p − Er F a, n, p [A1.27]
If n – namely, the number of periods (or subintervals) between the

valuation date and the expiry date – is very high, the stock price
multiplicative binomial law follows a log–normal distribution and the CRR
formula converges to that of Black and Scholes:
C = SΦ d − Ee Φ d [A1.28]
with:
d = , d = d − σ√τ and Φ x = e dt. [A1.29]

√ √
Appendix 2
Stochastic Differential Calculus
A2.1. Introduction to the diffusion process
The modeling of the share price used, in particular, in the context of the
determination of option valuation formulas in continuous time is based on
the use of stochastic differential calculus.
EXAMPLE.– Let xt be the price of a share on date t and x0 its price today. It is
assumed that the price increases by €3 per unit of time and that x0 = €1.
Thus: xt = xt-1 + 3, i.e. xt – xt-1 = 3 that we can still note: Δx = 3.Δt, where Δt
is 1 unit of time at the end of which the price has risen by €3.
EXAMPLE.– Let xt be the price of a share on date t and x0 its price today. It is
now assumed that the price increases by €18 per unit of time equal to 1 year
and that x0 = €1,000. Thus: xt = xt-1 + 18, i.e. xt – xt-1 = 18 that we can still
note: Δx = 18. Δt, where Δt is 1 unit of time at the end of which the price has
risen by €18.
If the unit of time is shortened and equal to 1 month, the change in the
price of this new reference period is equal to 12: 18/12 = €1.5. Thus, we
note: dx = 1.5.dt.
A2.2. Simple Brownian motion or Wiener process
Let Δx be the variation of the share price over a small time interval,
noted Δt.

It is assumed that Δx = Δz with Δz = ε√ and ε follows a standard

normal distribution which is classically noted: ε → N(0, 1).
The symmetry of the curve of the standard normal distribution

(representative of the density of probability of ε) shows that the area under
the curve to the left of the ordinate axis is equal to the area under the curve
to the right of the ordinate axis. Thus: P[ε > 0] = P[ε < 0].
In other words, at the end of each small time interval dt, ε is as likely to
take a positive value as to take a negative value.
PROPERTY.– It is then possible to characterize Δz using its expectation and

its standard deviation:
E(Δz) = E( √ )= √ E(ε) = √ . 0 = 0 [A2.1]
V(Δz) = V( √ ) = Δt .V(ε) = Δt .1 = Δt therefore Δz σ = √ [A2.2]
Finally:
Δx = Δz → N(0, √ ) [A2.3]
Validity of properties for a large time interval: the property that has just
been established remains valid for a large time interval denoted T,
corresponding to n small intervals Δt. In other words:
T = n.Δt [A2.4]
Time interval = T
Δt Δt Δt Δt
x0 x1 x2 xT-1 xT
Figure A2.1. Breakdown of time intervals
In this context, Δx should be replaced by x(T) – x(0). However:
x(T) – x(0) = ∑ Δ xi = ∑ Δzi= ∑ √Δt [A2.5]

Appendix 2 149
x(T) – x(0) = x(1) – x(0) = √ +x(2) – x(1) = √ +…+

x(T)-x(T-1) = √ [A2.6]
Thus:
x(T) – x(0) = 1 √Δt + 2 √Δt +… + n √Δt = ∑ i √Δt [A2.7]
As in the case of a price evolution over a small time interval, it is possible

to characterize x (T) – x(0) using its expectation and its standard deviation:
E[x(T) - x(0)] = E∑  √Δ = √Δ ∑ (i) = √Δ . 0 = 0 [A2.8]
V[x(T) - x(0)] = V∑  √Δ = √Δ ∑ (i)

= Δ .∑ . 1 = n. Δ = T [A2.9]
We then find for a large time interval T:
x(T) – x(0) → N(0, T) [A2.10]
It is also possible to write that:
x(T) → N[x(0), T] [A2.11]
If Δt tends to 0, which amounts to considering a subdivision of time T

into extremely small intervals, the share price undergoes on the period T an
infinitely large number of variations. In other words, the process of evolution
of the share price is continuous, which leads to replacing Δt by dt, Δx by dx
and Δz by dz.
In this case, dx → N(0, √ ) which defines a Wiener process

(or Brownian motion with tendency).
A2.3. Brownian motion with tendency
DEFINITION.– In this case, the evolution of the price depends not only on a
random process but also on a central tendency parameter, or drift denoted
below by a.
In other words:
dx = a.dt + b.dz with dz = ε dt and ε → N(0, 1) [A2.12]
PROPERTY.– On a small time interval Δt, the process, in discrete time, is

written:
Δx = a. Δt + b. Δz [A2.13]
In that case:
E (Δx) = E (a. Δt + b. Δz) = a. Δt + b.E(Δz) [A2.14]
since only Δz has a random component.
Thus:
E (Δx) = a. Δt + b.E(ε√Δdt ) = a. Δt + b. √Δt E(ε) = a. Δt + 0 = aΔt [A2.15]
V (Δx) = V (a. Δt + b. Δz) = 0 + b2 .V (Δz)
= b2 .V(ε.√Δt ) = b2 Δt V(ε) = b2 Δt [A2.16]
Finally:
Δx →N (a Δt, b √Δt ) [A2.17]
By subdividing a period T into n time intervals Δt (i.e. T = n. Δt the

variation of the price becomes over this period T:
x(T) - x (0) = ∑ Δxi [A2.18]
Since:
E[(x(T)- x(0)]=E(∑ Δxi) = ∑ E(Δxi) = n.aΔt = a.T [A2.19]
and:
V[(x(T)- x(0)] =V(∑ Δxi) = ∑ V(Δxi) = ∑ b √Δt =b².Δt∑ 1 =

n.b²Δt = b²T [A2.20]
Finally:
Appendix 2 151
x(T) – x(0) → N (aT, b√T ) or else: x(T) → N[x(0) + aT, b√T ]

[A2.21]
A2.4. Ito process and the special case of geometric Brownian

motion
This process corresponds to a variation of x in continuous time defined

by:
dx = a(x, t).dt + b(x, t).dz [A2.22]
a and b being then functions of the two variables x and t.
It is possible to calculate the expectation and the variance of dx:
E(dx) = a(x, t).dt because E(dz) = E(ε√Δt ) = √Δt E(ε) = 0 [A2.23]
V(dx) = b² (x, t).dt.V(ε) = b² (x, t).dt.1= b2 (x, t).dt [A2.24]
Therefore:
dx → N[a(x, t).dt, b(x, t) √dt ] [A2.25]
with:
– a(x,t) = instantaneous tendency;
– b(x,t) = instantaneous variance.
The geometric Brownian motion that defines the evolution of the return
of a share is a special case of Ito process assuming that:
a(x, t) = μ.x [A2.26]
and b(x, t) = σ.x [A2.27]
Since:
dx = μ.x.dt + σ.x.dz [A2.28]
Thanks to Ito’s lemma, it is possible to establish that such a process

defines a log–normal law.
A.2.5. Ito’s lemma
If a variable x follows an Ito process [dx = a(x, t).dt + b(x, t).dz], then a
function of this variable and of time [F(x, t)] also follows an Ito process.
Ito’s lemma is established from the Taylor formula with two variables x
and t:
² ² ²
ΔF = Δt + Δx + Δt² + Δx² + Δt. Δx +… [A2.29]
² ²
I.e.:
Δx = a(x, t). Δt + b(x, t). Δz = a(x, t). Δt + b(x, t). ε. √t with

ε → N(0, 1) [A2.30]
To reduce the notations, it is noted, later:
Δx = a.Δt + bε √t [A2.31]
Ito’s lemma leads us to consider only the terms in Δx and Δt of degree

equal to 1, which leads naturally to eliminate (by truncation) all the terms of
the development of ΔF from the fourth one. On the other hand, the third term
must be preserved. In fact:
Δx2 = (a.Δt + bε √t )² = a² Δt² + b²ε² Δt+2ab Δt 3/2= b²ε² Δt [A2.32]
by truncation.
However:
E(b2ε2.Δt) = b2.Δt .E(ε2) and E(ε2) = V(ε) +[E(ε)]2 = 1 + 0 = 1 [A2.33]
so:
E(b2ε2.Δt) = b2.Δt [A2.34]
In addition:
V(b2ε2.Δt) = b4 .Δt2.V (ε2) [A2.35]
which tends to 0 when Δt tends to 0.

Appendix 2 153
Therefore:
lim b2ε2.Δt = b2.Δt when Δt tends to 0 [A2.36]
Considering a subdivision of time into incredibly small intervals dt, and

therefore in continuous time, the application of the Taylor formula becomes:
²
dF(x, t) = dt + dx + b²dt [A2.37]
²
²
dF(x, t) = dt + (a. dt + b. dz) + b²dt [A2.38]
²
Consequently, returning to the original notations, namely:

– a = a(x, t) ;
– b = b(x, t).
It follows that:
²
dF(x, t) = [ + a(x, t) + b² (x, t) + ]dt + b (x, t) dz [A2.39]
²
A2.6. Log–normal distribution of the stock price
If dx =μ.x.dt +σ.x.dz, then Ito’s lemma can be used to find the following
process:
F(x, t) = ln(x) = F(x) [A2.40]
Thus:
( ,) ( )
= = [A2.41]
( ,) ( )
= and =− [A2.42]
As:
a(x, t) = μ x. dt and b(x, t) = σx. dt [A2.43]
dF = 0 + − . dt + σx dz [A2.44]
dF = μ − dt + σ. dz [A2.45]
and:
dlnx = lnx − lnx = μ − dt + σ. dz [A2.46]
lnx = lnx + μ − dt + σ. dz [A2.47]
.
x = x .e [A2.48]
As dF defines a geometric Brownian motion with the derivative:
dF → N μ− . dt, σ√dt or dlnx → N μ− . dt, σ√dt [A2.49]
then dx is a random variable with the parameters of a normal distribution that

are:
μ− . dt and σ√dt [A2.50]
By taking the rate of return μ equal to the interest rate r, the risk-neutral
parameters of the stock price are implicitly described. Then:
.
S = S .e + σ. ε. √dt [A2.51]
Appendix 3
Test of the Black and Scholes

Formula and Return on the
Log–Normal Distribution
A3.1. Monte Carlo simulations and test of the Black and Scholes
formula
The premium of a call is the current value of the scheduled repayments at

maturity:
C=e . E max 0; S − E [A3.1]
If the spot of the underlying asset defines a geometric Brownian motion:
. .
S = S .e [A3.2]
where:
dz = ε√τ [A3.3]
from where:
. . √
S = S .e [A3.4]

then:
. . √
C=e . E max 0; S . e −E [A3.5]
The value of C can be approximated thanks to the simulations obtained

by the Monte Carlo method:
– simulations of many values of ε. Since ε is a random variable that is
normally distributed with a mean of 0 and a variance t, its values can be
obtained on Excel thanks to the following function:
= RAND()
– calculation of the corresponding values of ST for each value of ε:

. . √
S = S .e
in a risk-neutral environment;
– discounted repayment calculation for each value of

. . √
S =e . max 0; S . e −E ;
– calculation of the average of the different discounted refunds which

depends on the premium of the call:
. . √
C=e . E max 0; S . e −E .
A3.2. Return on the normal–log distribution
Assuming Y = lnX → N m, σ , it is possible to determine the density and

the mean of X.
Since Y = ln X, X = eY.
Let us set the distribution function F and its density f:
FX(x) = P[X < x] = P[eY < x] = P[Y < lnx] = FY(lnx) [A3.6]
Appendix 3 157
Then:
fX(x) = F’X(x) = F’Y(lnx) = f lnx [A3.7]
Since lnx is defined for x > 0:

– if x < 0, fX(x) = 0; [A3.8]
– if x > 0, fX(x) = .e . [A3.9]

. .√
E X = xf x dx = xf x dx + xf x dx
1
=0+ . xe dx
x. σ. √2π
E X = . e dx [A3.10]
.√
Note:
u= [A3.11]
then:
x=e =ϕ u [A3.12]
from where:
ϕ u = σe [A3.13]
and:
ϕ u = [A3.14]
Therefore:
1 1
E X = . e . σe . du = . e . du
σ. √2π √2π
e
E X = . e . du
√2π
E X = . e . du [A3.15]
√
Let:
v=u−σ [A3.16]
then:
u = v + σ = ϕ u [A3.17]
from where:
ϕ u =1 [A3.18]
and:
ϕ v =v−σ [A3.19]
Finally:
E X = . e . dv and E X = e [A3.20]
√
Appendix 4
Demonstration of the Black

and Scholes Formula
C=e . E max(0; S − E) [A4.1]
It is assumed that lnS follows a normal distribution of parameters m and s

where:
m = ln S + μ − . τ and S = σ√τ [A4.2]
In this case, S follows a log–normal law.
The density of S is:
f(x) = .e si x > 0 (x) = 0 if x ≤ 0 [A4.3]

. √
The mean of S is:
E(S) = e [A4.4]
Moreover, for a continuous variable X:
E(X) = xf(x). dx [A4.5]
so:
C=e . max(0; S − E) . f(S). dS [A4.6]

where f is the density of the log–normal law.
It is possible to break down this integral into two terms:
C=e . max(0; S − E) . f(S). dS + e . max(0; S −

E) . f(S). dS [A4.7]
Now, if x is less than E, then max (0, S – E) = 0, so the first integral is

zero.
If x is greater than E, then max (0, S – E) = S – E.
Thus:
C=e . (S − E) . f(S). dS [A4.8]
C=e . S. f(S). dS − E. e . f(S). dS [A4.9]
Now S, as an integration variable, is a dummy variable. In other words, it

will not appear in the final result. We can then replace S, for example, by x.
Thus:
C=e . x. f(x). dx − E. e . f(x). dx [A4.10]
Replacing f with the expression of density:
1
C=e . x. .e . dx −
x. S√2π
E. e . .e . dx [A4.11]
. √
1
C=e . e . dx
S√2π
−E. e . .e . dx [A4.12]
√
Appendix 4 161
Either the change of variable:
u= [A4.13]
Since:
x=e = ϕ(u) [A4.14]
ϕ (u) = S. e [A4.15]
and:
ϕ (u) = [A4.16]
Thus:
1
C=e . e S. e du −
S√2π
E. e . .e . S. e du [A4.17]
√
By simplifying the first integral by S and the second by S and esu+m:
1
C = e . e du
√2π
−E. e . .e . du [A4.18]
√
However:
1 1
e du = .e . du
√2π √2π
1
− .e . du
√2π
=1−ϕ =ϕ [A4.19]
Thus:
( )
C = e .e e du − E. e .ϕ [A4.20]
√
By taking out of the first integral:
( )
C = e .e e du − E. e .ϕ [A4.21]
√
Let a new change of variable for the first integral:
v = u − S then: u = v + S = ϕ(v) [A4.22]
Thus:
ϕ (v) = 1 and − ϕ (v) = v − S [A4.23]
Since:
C = e .e e dv − E. e .ϕ [A4.24]
√
C = e .e .ϕ S − − E. e .ϕ [A4.25]
Replacing S and m with the values recalled in equations [A4.2]:
. .
.
C = e .e . ϕ σ√τ − −
√
E. e .ϕ [A4.26]
C=e .S e .ϕ − E. e .ϕ [A4.27]
√
In a risk-neutral environment, we can consider that μ= r.

Appendix 4 163
Thus:
C=e .S e .ϕ − E. e .ϕ [A4.28]
√ √
C = S .ϕ − E. e .ϕ [A4.29]
√ √
I.e.:
d = and d = [A4.30]
√ √
d − σ√τ = − σ√τ = = [A4.31]

√ √ √
Conclusion:
C = S ϕ(d ) − E. e ϕ(d ) [A4.32]
with:
d = [A4.33]
√
and:
d = d − σ√τ [A4.34]
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Index
A, B, C Cox, Ross and Rubinstein (CRR), 1,

3, 12–14, 18, 20, 21, 23, 29, 30, 35,
acquisition strategies, 48, 88, 98,
41, 42, 44, 123, 130, 131, 136,
106, 136
141, 146
arbitrage portfolio, 15, 18, 59,
69, 78
D, E, F
binomial tree, 22, 132
Black and Scholes, 1–3, 10, 12, differential equation, 47, 54, 55, 59,
14–18, 20, 21, 28, 30, 35–37, 71, 72, 75, 77, 83, 86
39, 41, 42, 44, 47, 66, 68, Discounted Cash Flows (DCF), 3, 11,
113, 114, 117, 122, 136, 146, 32, 44, 110–112, 136, 137
155, 159 diversification discount, 88, 89
Brownian motion dividend, 2, 3, 17, 18, 36, 41, 42, 81,
geometric, 15, 40, 42, 49, 70, 85, 82, 99, 110, 111
86, 102, 151, 154, 155 exercise price, 4, 5, 12, 13, 17, 36,
specific, 42 45, 49, 53, 63, 67, 78, 82, 90, 93,
call, see also put, 12–15, 17, 20, 95, 103, 110–112, 116, 132, 136
22, 28, 29, 31, 39, 41, 50, 51, flexibility, 1, 2, 5, 7, 10, 11, 23, 47,
53, 54, 81, 130, 141, 144, 145, 49, 64, 99, 100, 106, 108, 113, 119,
155, 156 130, 133, 135, 136
convenience yield, 35, 48, 58, 66, futures contracts, 41
69–71, 74
costs(s) I, J, M
of bankruptcy, 103, 105
opportunity, 104, 110 in the money, see also out the money,
production, 5, 49, 52, 58, 59, 64 13, 14, 36, 144
storage, 35 indebtedness, 7, 91, 92, 97, 129
transaction, 2, 36, 39, 44, 136 Ito’s lemma, 15, 70, 72, 77, 86,
151–153

joint ventures, 48, 66, 68, 99 put, see also call, 12, 13, 25, 26, 28,
Model 30, 41, 50, 51
binomial, 21, 23, 28–30, 103, rate
130, 131 distribution, 8, 42, 68
with jumps, 49, 64 growth, 22, 52, 57, 85, 86, 90
Monte-Carlo, 40, 43, 135 of return, 13, 17, 31, 39, 42,
52, 79, 82, 86, 111, 141,
O, P, R 142, 154
risk-free, 17, 18, 22, 31, 32, 60,
option premium, 3, 12, 15, 44, 53,
64, 67, 68, 71, 72, 80, 109,
54, 112
114–116, 124, 129, 130, 136,
optional interactions, 48
141, 142
options(s)
return, 15, 31, 38, 52, 53, 69–72,
abandonment, 5, 19, 23–26,
80, 82, 87, 98, 109, 110, 115,
28, 30, 31, 44, 47, 85–87,
141, 151
113, 115
right moment, 5, 49, 63, 68, 78, 95,
American, 25, 41
106, 107
carry, 5, 19, 48, 51, 54, 59, 62, 65,
98, 107, 108
S, T, U, V
closing, 76
combined, 2 smile, 36, 42
development, 6, 31 spot, see also underlying, 41, 69–71,
divestiture, 100 76, 77, 155
European, 3, 25 spread, 91, 97
exchange, 6, 65–67, 113, 114 standard deviation, 4, 12, 19, 36,
expanding, 7, 32 37, 43, 69, 79, 80, 83, 84, 86,
financial, 1–3, 20, 44, 84, 136 135, 148, 149
growth, 4, 19–23, 26, 28–30, time
90–97, 99, 103, 132, 136 agency theories, 89
of learning, 5 continuous, 2, 3, 12, 14, 17, 18, 20,
real, 1–4, 6–8, 10, 11, 19, 20, 28, 28–31, 36, 37, 40, 41, 44, 64,
42, 44, 45, 47–52, 62, 64–66, 82, 136, 147, 151, 153
68, 89, 90, 98–100, 106, 107, discrete, 2, 3, 12, 13, 18, 20,
136, 137 23–30, 36, 37, 40, 41, 44,
resale, 26 136, 141, 150
out the money, see also in the money, Timing, 77, 78, 82, 84
13, 36, 84 underlying, see also spot, 2–4, 12–15,
partial differential, 16, 18, 54, 55, 58, 17, 19, 20, 29, 36, 37, 39, 41,
93, 96 42, 44, 48, 50, 53, 54, 64, 67,
pricing, 41, 85, 87 69–72, 78, 84, 90, 94, 97, 99,
process 111–114, 116, 120, 121, 135,
of spreading, 85, 147 136, 141, 155
Poisson, 40, 64
Index 175
value time, 4, 12, 34, 112, 116, 119

adjusted (ANPV), 19, 20, 23, 25, volatility, 1, 2, 4, 12, 15, 17, 29, 31,
27–31, 110, 130, 133 32, 35–40, 42–44, 52, 62, 66–68,
intrinsic, 12, 34, 53, 112, 113, 116, 70, 78, 79, 82, 84, 85, 89, 90, 101,
119, 137 110, 112–114, 116, 120, 131,
net present (NPV), 1, 2, 5, 6, 8–11, 135, 136
19, 21, 23, 25, 26, 29, 31, historic, 36, 37, 42, 43
43, 44, 51, 53, 57, 60, 77, 78, implicit, 36, 37, 42, 135
110, 121, 122, 126, 128–130, stochastic, 2, 36–38, 44, 135
133, 135
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Current and Emerging Issues in the Audiovisual Industry
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MICHAUD Thomas
Innovation, Between Science and Science Fiction
PELLÉ Sophie
Business, Innovation and Responsibility
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Value Creation in Management Accounting and Strategic Management:
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Innovation Engines: Entrepreneurs and Enterprises in a Turbulent World
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Knowledge Management and Innovation
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Banking Governance, Performance And Risk-Taking: Conventional Banks
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Entrepreneurial Ecosystems (Smart Innovation Set – Volume 2)
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The Entrepreneur (Smart Innovation Set – Volume 8)
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Collective Intelligence Development in Business
GALLAUD Delphine, LAPERCHE Blandine
Circular Economy, Industrial Ecology and Short Supply Chains
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Security and Privacy in the Digital Era
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Big Data, Open Data and Data Development
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PICARD Fabienne, TANGUY Corinne
Innovations and Techno-ecological Transition
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CASADELLA Vanessa, LIU Zeting, DIMITRI Uzunidis
Innovation Capabilities and Economic Development in Open Economies
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Innovation Capability Maturity Model
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GODÉ Cécile
Team Coordination in Extreme Environments
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Competitive Quality and Innovation
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Strategic Decisions and Weak Signals
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HABART-CORLOSQUET Marine, JANSSEN Jacques, MANCA Raimondo
VaR Methodology for Non-Gaussian Finance
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DAL PONT Jean-Pierre
Process Engineering and Industrial Management
MAILLARD Pierre
Competitive Quality Strategies
POMEROL Jean-Charles
Decision-Making and Action
SZYLAR Christian
UCITS Handbook
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LESCA Nicolas
Environmental Scanning and Sustainable Development
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Weak Signals for Strategic Intelligence: Anticipation Tool for Managers
MERCIER-LAURENT Eunika
Innovation Ecosystems
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SZYLAR Christian
Risk Management under UCITS III/IV
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COHEN Corine
Business Intelligence
ZANINETTI Jean-Marc
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CORSI Patrick, DULIEU Mike
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of Globalization
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AMMI Chantal
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BOUGHZALA Imed, ERMINE Jean-Louis
Trends in Enterprise Knowledge Management
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Innovation Engineering: the Power of Intangible Networks

Investment Decision-Making Using Optional Models (2019)

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Investment Decision-making Using Optional Models

Modern Finance, Management Innovation

ISTE Ltd John Wiley & Sons, Inc.

© ISTE Ltd 2019

Library of Congress Control Number: 2019948429

British Library Cataloguing-in-Publication Data

Chapter 1. Risk and Flexibility Integration in Valuation . . . . . . . . . 1

Chapter 2. Optional Modeling of Investment Choices and

2.2.2. Opportunity to postpone decision-making to infinity . . . . . . . . . 52

Chapter 3. Data Generation Applied to Strategic and

Appendix 1. Demonstration of the CRR Formula . . . . . . . . . . . . . 141

Appendix 2. Stochastic Differential Calculus . . . . . . . . . . . . . . . . 147

Appendix 3. Test of the Black and Scholes Formula and

Appendix 4. Demonstration of the Black and

In order to create value, companies must allocate their resources

This notion of risk is essential in the valuation method by the real

According to Leshchiy (2015), real options are the junction between

According to Levyne and Sahut (2008), “investment projects are for

Therefore, for a given level of investment irreversibility, the real options

Table I.1. Real options value

1 Specific to the company or industry to which it belongs.

Chapter 1 will be devoted to the development of a theoretical framework

Risk and Flexibility

The investment must be identified as an entry fee that provides access to

Investment Decision-making Using Optional Models,

After the realization of a pragmatic analogy as to the different parameters

1.2. The scope of real options

study, we see that real options particularly convince large industrial

The valuation models of real options rely on paradigms regarding the

1.2.1. The concept of real options

Real options involve real activities unlike financial options that

In this context, there is an analogy between the characteristics of an

underlying is a financial asset. Financial options are specific contracts traded

Table 1.1. Analogy between the parameters of the real option

Amran and Kulatilaka (1999) distinguish seven categories of real options:

any time a project because it is disappointing. The standard valuation

– the option of expanding or reducing production favors the variability

This classification is taken up by Smit and Trigeorgis (2004), who stress

1.2.2. Empirical use of real options

Graham and Harvey (2001) conducted a survey of 392 CFOs regarding,

In addition, the indebtedness of the sample is fairly uniform insofar as

According to this study, the frequency of its application is greater in

% always Size PER

NPV 74.93 3.08 2.83 3.42 3.30 3.27

Payback period 56.74 2.53 2.72 2.25 2.55 2.41

Barrier rate 56.94 2.48 2.13 2.95 2.78 2.87

Multiples 38.92 1.89 1.79 2.01 1.97 2.11

Real options 26.59 1.47 1.40 1.57 1.31 1.55

Value-at-risk 13.66 0.95 0.76 1.22 0.84 0.86

Adjusted NPV 10.78 0.85 0.93 0.72 0.97 0.69

Low High Yes No Prod. Other Low High

NPV 2.84 3.39 3.35 2.76 3.23 2.82 3.35 2.77

Multiples 1.67 2.12 1.88 1.88 1.85 2.00 1.85 2.04

Value-at-risk 0.78 1.10 1.04 0.82 0.95 0.92 0.95 0.86

In order to recognize their potential utility, Hartmann and Hassan (2006)

Research Preliminary development Later development

Table 1.4. The pharmaceutical process of R&D

Preclinical 76% 12% 24% 24% 12% 4% 0% 4%

Table 1.5. The inventory of the responses of pharmaceutical

Based on a questionnaire submitted in 2004, Hartmann and Hassan

According to Table 1.5, 23–26% of pharmaceutical groups use options

1.2.3. Paradigms in options

The financial option is a derivative product used to build speculative