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Valuing Real Options Projects with Correlated

Uncertainties
Luiz E. Brandão
1
and James S. Dyer
2
1
IAG Business School, Pontifícia Universidade Católica do Rio de Janeiro, Rio de Janeiro, RJ,
22451-900, Brazil
brandao@iag.puc-rio.br
2
McCombs School of Business, University of Texas at Austin, Austin, Texas 78712, United
States
jim.dyer@mccombs.utexas.edu
Abstract. Contingent claims are traditionally priced through the use of
replicating portfolios, or equivalently, risk neutral valuation. When markets are
incomplete, as occurs with many projects and is often the case with claims on
real assets when firms are subject to private, project specific risks, these risks
cannot be hedged and a replicating portfolio cannot be construed. We proposed
a modified approach that enhances the methodology originally developed by
Copeland and Antikarov (2003) and provides a practical method for pricing
project where management flexibility and correlated risks are present, using the
concept of partially complete markets of Smith and Nau (1995).
Keywords: Real Options, Correlated Uncertainties, Decision Analysis
1 Introduction
It is widely recognized that discounted cash flow methods do not adequately value
contingent claims, such as options on financial or real assets. The solution to the
problem of valuing financial options was pioneered by Black & Scholes [1] and
Merton [2] and this approach has been further extended to the valuation of
investments in real assets that present managerial flexibility in an approach known as
the real options methodology.
Contingent claims are traditionally priced through the use of a market asset or
portfolio of marketed assets that replicate the payoffs of the claim in all states and
times. Since this replicating portfolio offers the same payoffs and risks as the claim,
arbitrage considerations imply that their prices must also be the same. While this
analysis is straightforward in the case of complete markets, the markets for real assets
are usually incomplete as the number of marketed assets is insufficient to set up the
replicating portfolio.
Market risks are due to uncertainties that are market correlated and can be fully
hedged by trading in securities. An example is the risk derived from the uncertainty
over future oil prices in an oil exploration and development project. For projects
Journal of Real Options 1 (2011) 18-32
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where a replicating portfolio can be constructed and valued, the market is complete
and all project risks can be hedged by shorting this portfolio. On the other hand, even
though the basic project uncertainty may be market related, there may not be an active
traded market for this particular product or commodity, or there may be project or
firm specific uncertainties, such as the uncertainty over the size of the oil reservoir or
discrete “lumpy” events that may have a one time effect on the project and are not
correlated with the market. In these cases, the project cannot be hedged with market
securities and markets are incomplete for projects that bear these types of risks.
When the output of the project is a traded commodity, a standard solution in the
real options literature [3-4] is to use this asset to hedge the projects risks and construct
the replicating portfolio. Another approach is to treat the project without options as a
traded asset, where its present value is assumed to be its true market value, and to use
the project to create an underlying portfolio to value options associated with the
project [5]. Both approaches address the problem by making assumptions that
transform an incomplete market setting into a complete one.
The incomplete market problem can only be addressed directly if we are willing to
place restrictive assumptions on the investors’ or managers’ utility functions. Smith
and Nau [6] introduce the concept of a partially complete market where the market is
complete for market risks, and private events convey no information about future
market events. This implies that if
m
i
e and
1
p
t
e
÷
are the vectors of all possible market
and private states at t and t-1 respectively, then
m
i
e and
1
p
t
e
÷
are independent. Under
this framework, the market component of the project cash flows is valued using the
traditional complete market setting, and the private component may be priced
assuming risk neutrality if the investors are sufficiently diversified, or by using a
utility function that reflects the investor’s subjective beliefs and preferences
otherwise.
There are, however, projects where the distinction between market and private
risks is either not so clear, or not a meaningful concept, such as when these two
uncertainties are correlated in some way. An example of this is the uncertain change
in oil drilling rig rates, which cannot be directly hedged in any existing markets, but
nonetheless, are loosely correlated with oil prices.
In this paper we demonstrate how the correlation between market and private risks
can be addressed within the framework of a contingent claims valuation when private
risks are conditioned to market risk. We solve this problem with a discrete time model
based with risk neutral probabilities, and provide a practical computational solution
for this approach based on the use of binomial decision trees. This approach is similar
to the work of Wang and Dyer [7], who develop a copula based approach for
modeling dependent multivariate uncertainties, but differs from the Smith and Nau
approach in the sense that Smith and Nau do not explicitly consider the problem of
correlation between the market and private uncertainties.
The remainder of the paper is organized as follows: Section 2 introduces the
concept decision tree analysis and risk neutral probabilities. Section 3 presents an
enhanced approach to project valuation with correlated private uncertainty. In Section
4 we apply the model to solve a sample problem and in Section 5 we conclude with a
Journal of Real Options 1 (2011) 18-32
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summary and discussion of further research issues regarding model formulation and
solution procedures.
2 Decision Tree Analysis for Real Option Valuation
Real options derive their value from the managerial flexibility present in a project,
which allows firms to affect the uncertain future cash flows of a project in a way that
enhances expected returns or reduces expected losses. The flexibility to delay
investment in a project, for example, may be viewed as a call option on the project
where the required investment is the exercise price. Other typical project flexibilities
are the option to switch inputs or outputs or otherwise expand, abandon, suspend,
contract or resume operations in response to future uncertainties. Due to the option-
like characteristics of management flexibility, discounted cash flow methods cannot
be used to capture this value and one must resort to option pricing or decision analysis
methods.
Managerial flexibility can be modeled with decision tree analysis (DTA) by
incorporating the decision instances that allow the manager to maximize the value of
the project conditioned on the information available at that point in time, after several
uncertainties may have been resolved. A naïve approach to valuing projects with real
options would be simply to include decision nodes corresponding to project options
into a decision tree model of the project uncertainties, and to solve the problem using
the same risk-adjusted discount rate appropriate for the project without options.
Unfortunately, this naïve approach is incorrect because the optimization that occurs at
the decision nodes changes the expected future cash flows, and thus, the risk
characteristics of the project. As a consequence, the standard deviation of the project
cash flows with flexibility is not the same as that of the project without flexibility, and
the risk-adjusted discount rate initially determined for the project without options will
not be the same for the project with real options. However, real option problems can
be solved by DTA with the use of risk neutral probabilities, which implies that we can
discount the project cash flows at the risk free rate of return and make any necessary
adjustments for risk in the probabilities of each state of nature.


Fig. 1. The Project with Objective Probabilities and a Risk-adjusted Discount Rate
Up state
.50
59.1
Down state
.50
-19.1
Chance
Accept 20
Reject 0
Decision
20
Net Payoff
59.1 = 120/1.1 - 50
Net Payoff
-19.1 = 34/1.1 - 50
Journal of Real Options 1 (2011) 18-32
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We illustrate this concept with an example. Suppose there is a two state project
with equal chances of cash flows of $120 or $34 one year from now that has a risk-
adjusted discount rate of 10%, and which can be implemented at a cost of $50. The
expected present value of the project is $70 = [0.5($120) + 0.5($34)]/1.10 and the
NPV is $20, as shown in Fig. 1., where the square represents a decision, the circle
represents an uncertainty and the triangles represent path endpoints.
Suppose now that the decision to commit to the project can be deferred until next
year, after the true state of nature is revealed, and that the risk free rate is 8%. The
original discount rate of 10% cannot be used because the risk of the project has now
changed due to the option to defer the investment decision. On the other hand, a set
of risk neutral probabilities for the original project can be determined and used to
value the project with the deferral option, since the expected cash flows for both
problems are the same ($120 and $34).
While the correct risk-adjusted discount rate of a project with options is difficult to
determine due to the effect these options have on the project risk, the risk free rate of
return can be readily observed in the market. By switching from objective
probabilities to risk neutral probabilities, the project NPV with options can then be
estimated even without knowing the correct risk-adjusted discount rate. In this
example this can be done by solving for the risk neutral probability p
r
in
( ) $70 ($120) (1 )($34) / 1.05
r r
p p = + ÷
and we obtain p
r
= 0.4593.
The project with the option to defer has net payoffs of $120-$50=$70 in the up
state and zero in the down state as illustrated in Fig. 2. , as there will be no investment
if it is known beforehand that the down state will prevail. The net present value of the
project with the option to defer is $30.6 = [0.459($66.7) + 0.541($0)] / 1.05, up from
$20, which implies that the value of the option to defer is $10.62.


Fig. 2. Project with Risk Neutral Probabilities and Risk Free Discount Rate
The DTA model is based on the idea proposed by Copeland and Antikarov [5],
which requires two key assumptions: MAD (Marketed Asset Disclaimer), where the
present value of the project assumed to be the best estimate of its market value, and
that variations in the project returns follow a random walk. We refer the reader to
Accept 66.7
Reject 0
Decision
Up state
.459
66.7
Accept -15.2
Reject 0
Down state
.541
0
Chance
30.6
Net Payoff
(120 - 50)/1.05 = 66.7
Net Payoff
(34 - 50)/1.05 = -15.2
Journal of Real Options 1 (2011) 18-32
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both Copeland and Antikarov [5] and Brandão and Dyer [8] for a more thorough
discussion of these ideas.
While both these assumptions are also subject to a number of caveats, we will
adopt this point of view for the purpose of this discussion. Let V
i
be the value of a non
dividend paying project at time period i and V
i+1
/V
i
be its return over the time period
between i and i+1. Under the random walk assumption, the logarithm of the return
) / ln(
1 i i
V V
+
is normally distributed, and we define v and o
2
as the mean and variance
of this distribution. When the time period length is small, this stochastic model can be
expressed as an Arithmetic Brownian Motion (ABM) random walk process in the
form dz dt V d o v + = ln where dz dt c = is the standard Wiener process, (0,1) N c ~ .
Accordingly, changes in V
i
will be lognormally distributed, and can be modeled as a
Geometric Brownian Motion (GBM) stochastic process in the form
Vdz Vdt dV o µ + = where
2
2 µ v o = + . The random walk assumption implies that
any number of uncertainties in the model of the project can be combined into one
single representative uncertainty, the uncertainty associated with the stochastic
process of the project value V, and the parameters of this process can be obtained
from a Monte Carlo simulation of the project cash flows.
The value of the underlying project at time i is determined by simply discounting
the expected cash flows
| | { }
, = 1, 2, ...,
i
E C i m
at the risk-adjusted discount rate µ,
such that
| |
( )
( )
m
u t i
i
i
V E C t e dt
÷ ÷
=
}
. If the project pays dividends, then its value will
decrease in each period by the amount of dividends that is paid out. We assume these
dividends are equal to the cash flows in each period. The distribution of V
i
can be
fully defined by the mean and standard deviation of the project returns. Assuming that
markets are efficient, purchasing the project at its present value guarantees a zero
NPV and the expected return of the project µ will be exactly the same as its risk-
adjusted discount rate. In this sense, the mean return is exogenously defined and is
usually set equal to the firm’s WACC. The volatility o of the returns can be
determined from a Monte Carlo simulation of the stochastic process
ln d V vdt dz o = + where
( )
1 0
ln v V V =
%
% and . )
~
( v v = E The value of the project can
be modeled in time as a GBM stochastic process by means of a discrete recombinant
binomial lattice according to the model of Cox, Ross and Rubinstein (CCR) [9]. The
pre-dividend value of the project in each period and state is given by
, 0
i j j
i j
V V u d
÷
=
,
where
t
u e
o A
= and
t
d e
o ÷ A
= are the parameters governing the size of the up and
down movements in the lattice. The objective probability of an up movement
occurring is
.t
e d
p
u d
µ
µ
÷
=
÷
, where i = period (i = 0, 1, 2, ..., m) and j = state (j = 0, 1, 2,
..., i). The continuous time stochastic process associated with this dividend-paying
project is
( )
t
dV Vdt Vdz µ o o = ÷ +
, where δ
t
is the instantaneous dividend distribution
rate at time t. Under uncertainty, the pre-dividend value of the project V
ij
in period i,
Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 22
state j, is given by the recursive equation
1
, 0
1
(1 )
i
i j j
i j k
k
V V u d o
÷
÷
=
= ÷
[
where the
probability P
i,j
that the value V
ij
will occur is
,
(1 )
i j j
i j
i
P p p
j
÷
| |
= ÷
|
\ .
.
The value of the project can be modeled in time as a GBM stochastic process by
means of a discrete recombinant binomial lattice according to the CRR model. We
choose to model the options as function of the project cash flows rather than on the
value, even though both approaches are equivalent. These cash flows, which we will
call pseudo cash flows (C
i,j
), will themselves be a function of the expected cash flows
of the project C
i
(i = 1, 2, ..., m), of µ and of the parameters u and d of the binomial
mode and can be shown to be defined as:

1 1
1,
1
1, ,
1
1, 1 ,
1
1
(1 )
2, 3,..., 0,1, 2,...
(1 )
j j
j
i
i j i j
i
i
i j i j
i
C
C u d i
C
C C u
C
i m j i
C
C C d
C
µ
µ
µ
÷
+
+
+
+ +
¹
= =
`
+
)
¹
= ·
¦
+
¦
= =
`
¦
= ·
¦ +
)
(1)
Since we are using risk neutral probabilities
rt
r
e d
p
u d
÷
=
÷
, these cash flows are
discounted at the risk free rate to arrive at the present value of the project at time
t = 0.
3 Correlated uncertainties
Situations where risks are correlated bring an additional level of complexity to the
valuation problem. The consolidation of all the market uncertainties that affect the
project resulted in the lognormal diffusion process for the project value V, which we
defined in the previous steps. We now consider the case where an additional market
or private uncertainty is conditional on the consolidated market uncertainties by
means of a correlation factor ρ and derive a binomial approximation following the
CRR model, but now with conditional probabilities.
Let V and P be the value of the project and of the additional uncertainty at time t,
µ
V
and µ
P
the respective drift rates, σ
V
and σ
P
the volatilities of each process and
and
V P
dz dz
the standard Wiener processes respectively for V and P. The diffusion
process for these risks is then given by:


where
, (0,1)
V V V V V
P P P P P i
dV Vdt Vdz dz dt
dP Pdt Pdz dz dt N
µ o c
µ o c c
= + =
= + =


Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 23
with correlation
| |
, ,
.
V P
V P dz dz V P
E dz dz dt µ µ = =

Since we will be using risk neutral probabilities to obtain a solution, we must
substitute the drift rate for the risk free rate r = r(t), and the process becomes
V V
dV rVdt Vdz o = +
and
P P
dP rPdt Pdz o = +
. In the binomial mode each asset price
can go up or down at each step, so that we will have four possible states after one time
period, each with probability p
i
, i = 1,2,3,4, as shown in Fig. 3.

V, P
u
V
V, u
P
P
p
1
= p(u
V
,u
P
)
p
2
= p(u
V
,d
P
)
p
3
= p(d
V
,u
P
)
p
4
= p(d
V
,d
P
)
Probabilities
d
V
V, d
P
P
u
V
V, d
P
P
d
V
V, u
P
P

Fig. 3. States and Probabilities
The size of the up and down movements (u
V
, u
P
, d
V
, d
P
) and the value of the
probabilities p
i
must be such that the discrete probability distribution converges to the
bivariate lognormal distribution when the time period tends to zero. We achieve this
by equating the mean, variance and correlation of the binomial and continuous time
models, as suggested by Boyle, Evnine and Gibbs [10]. In analogy with CRR, we
make u
j
d
j
=1, and
j
t
j
u e
o A
=
, j = V,P. The derivation of the formulas is provided in
the appendix. The conditional probabilities for the uncertainties are:
( | ) (( , ) , ), 1, 2, 3, 4
( )
k
i j
j
p
P P V j u d i u d k
P V
= = = =
where
( )
r t
u
e d
P V
u d
A
÷
=
÷

1
( | )
4 ( )
V P
V P
u u
u
v v
t
P P V
P V
µ
o o
| |
+ + A +
|
\ .
=


1
( | )
4 ( )
V P
V P
u d
d
v v
t
P P V
P V
µ
o o
| |
+ ÷ A ÷
|
\ .
=

(2)

1
( | )
4 ( )
V P
V P
d u
u
v v
t
P P V
P V
µ
o o
| |
÷ ÷ A ÷
|
\ .
=


1
( | )
4 ( )
V P
V P
d d
d
v v
t
P P V
P V
µ
o o
| |
÷ + A +
|
\ .
=

Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 24
4 Example
We illustrate this approach to the evaluation of real options with a simple four-
period project. Due to limitations in the software used to model the problem, the
decision tree representation is essentially a binary tree augmented by decision nodes,
and it is not recombining like a binary lattice. This results in a large tree due to the
unnecessary duplication of nodes, but provides a visual interface and a convenient and
flexible modeling tool. We consider initially the case of a project subject to a market
uncertainty and next analyze the effects of a private uncertainty on the project value.
4.1 Project subject to market uncertainty
Consider a firm that has just developed a new product and is deciding whether to
invest in the manufacturing and marketing of this product. Due to the very
competitive nature of this market, the product life is expected to be no more than four
years. The spreadsheet with the expected value of the future cash flows and the
present value of the project at time zero is shown in Table 1. The risk-adjusted
discount rate is assumed to be 10% and the risk free rate is 5%.

0 1 2 3 4
Revenue 1000 1080 1166 1260
Variable Cost (400) (432) (467) (504)
Fixed Cost (240) (240) (240) (240)
Depreciation (300) (300) (300) (300)
EBIT 60 108 160 216
Tax Rate (50%) (30) (54) (80) (108)
Depreciation 300 300 300 300
Investment (1,200)
Cash Flow (1,200) 330 354 380 408

PV
0
= 1,157 WACC = 10%
Invest = (1,200)
NPV

= (43)
Table 1 – Project Expected Cash Flows
The present value of $1,157 is assumed to be the best estimate of the market value
of the project and is our base case value. Since the required investment is $1,200, the
project has a negative NPV, which indicates that it should not be implemented.
We assume that the project is subject to a single source of market uncertainty, the
future value of its revenue stream; although other sources of market uncertainties
could be easily incorporated into the model by adding additional uncertainty
distributions to the simulation. Suppose the future project revenues R follow a GBM
diffusion process with a mean α
R
= 7.70% (equivalent to a discrete annual growth of
8.0%) and volatility σ
R
= 30%. Using these parameters, a Monte Carlo simulation of
the project cash flows may be used to compute the standard deviation of
( )
1 0
ln / v V V =
%
% , and to obtain an estimate of the project volatility σ = 24.8%. Finally,
Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 25
we assume that the project rate of return is normally distributed, so the project value
will have a lognormal distribution at any point in time that may be approximated by a
binomial lattice.
Modeling the binomial approximation requires that we determine the values of u,
d, and the risk neutral probability p
r
, according to the formulas defined previously.
The pseudo cash flows of the project are computed using equations shown in (1), and
the value of the project is determined applying the usual procedures of dynamic
programming implemented in a binomial tree, and discounting the expected cash
flows at the risk free rate of return. Risk neutral probabilities are used to arrive at the
project expected value, which is the same as the one calculated with the spreadsheet.
Note that the values for o, µ, r and the project expected cash flows C
i
can be entered
as parameters in a decision tree model, and all the necessary formulae can be
incorporated into the tree structure. In effect, tree building can be greatly simplified
by developing a standard template for a binary tree for any given number of time
periods.
Once the project’s stochastic parameters are determined and the decision tree is
structured, the project options can be added with ease. Suppose the project can be
abandoned in years two and three for a constant terminal value of $350, and that there
exists an option to expand the project by 30% in year 2 at a cost of $100. Given the
binary tree representation, these options can be evaluated by simply inserting the
appropriate decision nodes in the time period that models the existing managerial
flexibility in each year.
The decision tree model is shown in Fig. 4. The project value, computed using the
same risk neutral probabilities, increases to $1,280, and the expansion option will be
exercised in all states of year 2, except one, while the abandon option will continue to
be exercised only in year 3, as can be seen by the lines in bold. Additional options and
time periods can be added in a straightforward manner.
4.2 Project subject to correlated uncertainties
Traditional financial theory seeks to obtain market values for assets, and assumes
that firms and/or their shareholders are sufficiently diversified so that they become
risk neutral in relation to private risks since these risks can be eliminated by an
adequate diversification strategy. In this case, the private, firm specific risks must be
computed at their expected values and discounted at the risk free rate in order to
estimate the market value of a project. On the other hand, for small family and owner
operated businesses, for employees that hold large stock investment in the firms they
work for or managers that have significant amount of stock options, this may not be
the case.

Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 26

Fig. 4. Decision Tree with Option to Expand and Abandon
To solve this problem we consider the partially complete market concept of Smith
and Nau [6] and decompose the project cash flows into their market and private
components and value each one separately: option pricing in complete markets for the
market risk and use a utility function that reflects the firm’s risk preferences to value
the private risk, if we consider an undiversified investor. In our example, the private
risk is due to the fact that the project’s cash flows are also affected by the efficiency
of the plant, which in turn is correlated with the firm’s manufacturing technology.
Since the firm’s technology cannot be hedged in the market, this results in a private
risk for which we have no way of determining an appropriate discount rate unless we
make restrictive assumptions about the firm’s utility function. We will also assume
that the efficiency of the plant is positively correlated with the project value, since a
T4
Continue [2044]
Abandon
302.3
[1688]
Dec 3
High
674.5 .538
[2044]
T4
Continue [1523]
Abandon
302.3
[1424]
Dec 3
Low
410.8 .462
[1523]
T3
Expand
-90.7
[1803]
T3
Continue [1642]
Abandon
317.5
[1119]
Dec 2
High
435.8 .538
[1803]
T4
Continue [1352]
Abandon
302.3
[1254]
Dec 3
High
410.8 .538
[1352]
T4
Continue [1035]
Abandon
302.3
[1093]
Dec 3
Low
250.1 .462
[1093]
T3
Expand
-90.7
[1233]
T3
Continue [1196]
Abandon
317.5
[949]
Dec 2
Low
265.4 .462
[1233]
T2
High
366.1 .538
[1540]
T4
Continue [1209]
Abandon
302.3
[1111]
Dec 3
High
410.8 .538
[1209]
T4
Continue [891.9]
Abandon
302.3
[950.1]
Dec 3
Low
250.1 .462
[950.1]
T3
Expand
-90.7
[1090]
T3
Continue [1053]
Abandon
317.5
[805.8]
Dec 2
High
265.4 .538
[1090]
T3
Expand
-90.7
[801.2]
T4
Continue [764.8]
Abandon
302.3
[879.3]
Dec 3
High
192.4 .538
[879.3]
T4
Continue [616.1]
Abandon
302.3
[804.1]
Dec 3
Low
117.2 .462
[804.1]
T3
Continue [844.6]
Abandon
317.5
[702]
Dec 2
Low
161.6 .462
[844.6]
T2
Low
223 .462
[976.4]
T1
[1280]
Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 27
greater cash flow stream from higher volumes and prices would generate
manufacturing economies of scale and more investment in manufacturing technology.
We assume that the plant operates with a mean efficiency of 80 %, volatility of
0.10 and correlation of ρ = 0.20. The conditional probabilities for the private risk are
determined from equations (2) and the private uncertainty is added as a chance node
in each period. Fig. 5. shows the model for the base case. If the investor is fully
diversified, the we would expect the value of the project to be smaller, since the mean
efficiency is less than 100%, and accordingly, solving the decision tree provides a
value of $1,058 for the base case, as compared to $1,157.


Fig. 5. Private Uncertainty: Base Case
The project options can be determined by inserting the appropriate decision nodes
in each time period in the same manner as before. The decision tree model is shown in
Fig. 6. , and the solution to this tree provides the value of $1,181.

Fig. 6. Model with correlated private risk
On the other hand, if the firm or its investors are not sufficiently diversified and
this investment represents a significant portion of their wealth, they may be risk
averse toward private risks. In this case, assuming an exponential utility function
( )
x RT
u x e
÷
= ÷ and a risk tolerance of $200, this level of risk aversion leads to the
High
T2*Priv2/(1+r)^2
Low
T2*Priv2/(1+r)^2
a
High
Low
Priv2
High
T1*Priv1/(1+r)
Low
T1*Priv1/(1+r)
T2
High
Low
Priv1 T1
High
T4*Priv4/(1+r)^4
Low
T4*Priv4/(1+r)^4
High
Low
Priv4
High
T3*Priv3/(1+r)^3
Low
T3*Priv3/(1+r)^3
T4
High
Low
Priv3
a
T3
Expand
-Invest/(1+r)^2
a
Continue
a
Abandon
Abn_Value/(1+r)^2
High
T2*Priv2/(1+r)^2
Low
T2*Priv2/(1+r)^2
Dec 2
High
Low
Priv2
High
T1*Priv1/(1+r)
Low
T1*Priv1/(1+r)
T2
High
Low
Priv1 T1
High
T4*Priv4/(1+r)^4
Low
T4*Priv4/(1+r)^4
High
Low
Priv4
Continue
T4
Abandon
Abn_Value/(1+r)^3
High
T3*Priv3/(1+r)^3
Low
T3*Priv3/(1+r)^3
Dec 3
High
Low
Priv3
a
T3
Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 28
project value decreasing to $1,134. The breakeven point for the risk tolerance factor is
$134, below which the optimal project strategy changes. For a further discussion on
the use of utility functions for investment valuation see Kasanen & Trigeorgis [11].
5 Conclusions and Recommendations
The method proposed represents a simple and straightforward way of
implementing real option valuation techniques using standard decision tree tools
easily available in the market. By modeling the correlated uncertainty explicitly,
private or otherwise, into the problem, a more accurate estimate of the project value
can be obtained that takes into account the possibility the different natures of these
uncertainties and their correlation.
Even for a simple model such as this one, the decision tree becomes large very
quickly. In most practical problems the complexity of the decision tree will be such
that full visualization will be impossible; however, even large problems with literally
millions of endpoints for the tree can be solved using this approach. Additional
computational efficiencies can be obtained by using specially coded algorithms,
although at the cost of having to forgo the simple user interface that decision tree
programs offer and the advantage of visual modeling and a logical representation.
Suggested extensions include the implementation of recombining lattice capability in
current decision tree generating software to cut down on processing time. While a n
period recombining binary lattice has a total of n(n+1)/2 nodes, a similar binary tree
has 2
n+1
-1 nodes, which becomes a significant difference for large values of n. On
the other hand, the extension of this model to projects with non-constant volatility can
be easily implemented, whereas the effect of changes in volatility cannot be modeled
with a recombining lattice.
Perhaps the primary caveat regarding this methodology for the evaluation of
projects with real options relates to the assumptions underlying the Copeland and
Antikarov [5] approach itself, since the use of decision trees is simply a
computational enhancement of their concepts. The use of the Market Asset
Disclaimer as the basis for creating a complete market for an asset that is not traded
may lead to significant errors, since the valuation is based on assumptions regarding
the project value that cannot be tested in the market place. For example, the
appropriate choice of the project discount rate for the project without options is left to
the discretion of the analyst, and the use of WACC may not be appropriate for all
projects. Therefore, it is important to realize that this thorny issue is not resolved by
this methodology.



Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 29
6 References
1. Black, F. and M. Scholes, The Pricing of Options and Corporate Liabilities.
The Journal of Political Economy, 1973. 81(3): p. 637-654.
2. Merton, R.C., Theory of Rational Option Pricing. Bell Journal of Economics
and Management Science, 1973(4): p. 141-183.
3. Dixit, A.K. and R.S. Pindyck, Investment under Uncertainty. 1994, Princeton:
Princeton University Press. 476.
4. Trigeorgis, L., Real options, Managerial Flexibility and Strategy in Resources
Allocation. 1996, Cambridge, Massachussets: MIT Press.
5. Copeland, T. and V. Antikarov, Real Options: A Practitioner’s Guide. 2003,
Texere, New York. 368.
6. Smith, J.E. and R.F. Nau, Valuing Risky Projects: Option Pricing Theory and
Decision Analysis. Management Science, 1995. 41(5): p. 795-816.
7. Wang, T. and J.S. Dyer, A copula based approach for modeling Dependence in
Decision Trees. Forthcoming in Operations Research, 2011.
8. Brandao, L. and J.S. Dyer, Decision analysis and real options: A discrete time
approach to real option valuation. Annals of Operations Research, 2005.
135(1): p. 21-39.
9. Cox, J.C., S.A. Ross, and M. Rubinstein, Option pricing: A simplified
approach. Journal of Financial Economics, 1979. 7(3): p. 229-263.
10. Boyle, P., J. Evnine, and S. Gibbs, Numerical evaluation of multivariate
contingent claims. Review of Financial Studies, 1989. 2(2): p. 241-250.
11. Kasanen, E., & Trigeorgis, L. (1994). A market utility approach to investment
valuation. European Journal of Operational Research, 74(2), 294-309.



Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 30
7 Appendix: Conditional probabilities for a bivariate
distribution
To simplify the analysis, we convert to the natural logarithm of the variables, so
that x
i
= ln(S
i
). It can then be shown through an Ito process that the log of a GBM is
an ABM of the form:
ln
2
ln , (0,1)
2
V
V V V
P
P P P i i i
dV dx r dt dz
dP dx r dt dz where dz dt N
o
o
o
o c c
| |
= = ÷ +
|
\ .
| |
= = ÷ + =
|
\ .



Discretizing the time steps we have:
V V V V
P P P P
x v t z
x v t z
o
o
A = A + A
A = A + A
where
2
2
i
i
v r
o
= ÷


The mean, variance and correlation of the continuous time process are:


| | | |
V V V V V
E x E v t z v t o A = A + A = A


| | | |
P P P P P
E x E v t z v t o A = A + A = A


| | | |
2 2
V V V
Var x E x E x ( A = A ÷ A
¸ ¸


But since
| | ( )
2
2
0
V V
E x v t A = A =
, we remain with
| |
2 2
V V V
Var x E x t o ( A = A = A
¸ ¸

| |
2
P P
Var x t o A = A

and finally,
| |
V P V P V P
E x x E z z o o ( A A = A A
¸ ¸
, but
| |
V P
t E z z µ A = A A
, so we have
| |
V P V P
E x x t o o µ A A = A

The discrete binomial distribution yields:
| |
1 2 3 4
( ) ( )
V V V V V
E x p x p x p x p x A = A + A + ÷A + ÷A


| |
1 2 3 4
( ) ( )
V V V
E x p p x p p x A = + A ÷ + A

| |
1 2 3 4
( ) ( )
P P P P P
E x p x p x p x p x A = A + ÷A + A + ÷A

| |
1 2 3 4
( ) ( )
P P P
E x p p x p p x A = + A ÷ + A

( ) ( )
2 2
2 2 2
1 2 3 4 V V V V V
E x E p x p x p x p x
(
( A = A + A + ÷A + ÷A
¸ ¸
¸ ¸

2 2
V V
E x x ( A = A
¸ ¸

Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 31
2 2
P P
E x x ( A = A
¸ ¸

| |
1 2 3 4 V P V P V P V P V P
E x x p x x p x x p x x p x x A A = A A ÷ A A ÷ A A + A A

| |
1 2 3 4
( )
V P V P
E x x p p p p x x A A = ÷ ÷ + A A

We equate the first and second moments of the discrete distribution to the
continuous distribution. Equating also the correlations and making the sum of the
probabilities add to one, we arrive at a system of six equations with six unknowns.


1 2 3 4
( ) ( )
V V V
v t p p x p p x A = + A ÷ + A
(1.1)
1 2 3 4
( ) ( )
P P P
v t p p x p p x A = + A ÷ + A
(1.2)
2 2
V V
t x o A = A
(1.3)
2 2
P P
t x o A = A (1.4)
1 2 3 4
( )
V P V P
t p p p p x x o o µA = ÷ ÷ + A A
(1.5)
1 2 3 4
1 p p p p + + + =
(1.6)
Solution:
V V P P
x t and x t o o A = A A = A
1
1
1
4
V P
V P
v v
p t µ
o o
| | | |
= + + A +
| |
|
\ . \ .
(1.7)
2
1
1
4
V P
V P
v v
p t µ
o o
| | | |
= + ÷ A ÷
| |
|
\ . \ .
(1.8)
3
1
1
4
V P
V P
v v
p t µ
o o
| | | |
= ÷ ÷ A ÷
| |
|
\ . \ .
(1.9)
4
1
1
4
V P
V P
v v
p t µ
o o
| | | |
= ÷ + A +
| |
|
\ . \ .
(1.10)
The conditional probabilities can be obtained from the joint probabilities of the
market and private uncertainties.
( )
( | ) (( , ) , )
( )
i j
i j
j
P P V
P P V j u d i u d
P V
·
= = =

where
( ) ( , ) , 1, 2, 3, 4
i j k
P P V p j u d i u d k · = = = =



Journal of Real Options 1 (2011) 18-32
ISSN 1799-2737 Open Access: http://www.rojournal.com 32