Real Options Valuation for Risky Projects

- by Jyoti Singh *

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Therefore, the cash flows from a properly managed project are not the same as those of a project in which initiation mindlessly entails implementation. In the properly managed project, managers will avoid the downside situation. The cash flows are consequently biased upwards and the overall expected value of the project will be superior to that of a traditionally valued project.

Alternatives for Valuing Risky Projects

Decision Analysis

Decision analysis (See Figure 1) is the approach to evaluate risky and asymmetric situations. It deals effectively with multiple scenarios and management decisions to truncate specific lines of development.

However, decision analysis cannot deal effectively with major projects that have financial implications over extended time because it assumes that the discount rate is the same over the entire life of the project. Yet, discount rates should depend upon the relative risk associated with a situation. To do discounted cash-flow correctly, discount rates for every decision has to be altered and it has to be done for all possible outcomes. This is simply not practical.

Figure 1: Example of product development involving an option, the initial decision to do the R&D provides the options to invest in completing the project.

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* Contributed by -
Jyoti Singh,
PGDBM 2006,
IMT, Ghaziabad.

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