Quarterly publication of the Multinational Finance Society, a non-profit corporation     ISSN 1096-1879

From Expected Cash Flows to Real Options
(Multinational Finance Journal, 2010, vol. 14, no. 1/2, pp. 1–27)

Thomas E. Copeland
CRA International, MIT

This article attempts to answer some of the most common questions about how to apply the theory of real options to practice. Its primary focus is on how to start with irregular expected cash flows of the underlying risky asset that do not follow any regular stochastic process and end up with a legitimate real options analysis. It is organized as follows. Section I is a simple numerical example. Section II discusses the necessary theory -- three key assumptions. Section III discusses how to estimate volatility. Section IV goes on to describe six short case examples where the solution process worked well. The paper discusses why traditional NPV methodology forces false mutually exclusive alternatives and how real options solves the problem, and illustrates how modularity of project construction can be more valuable than significant economies of scale. Section V discusses some of the areas where more research is needed to make the theory work well in practice.

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Real Options Analysis and the Assumptions of Corporate Finance: A Non-Technical Review
(Multinational Finance Journal, 2010, vol. 14, no. 1/2, pp. 29–71)

Tom Arnold
University of Richmond, USA
Richard L. Shockley, Jr.
Indiana University, USA  

This paper provides a non-technical presentation of the theoretical foundations of corporate financial decision making and the net present value (NPV) rule. Our objective is to show that the concepts of value and value creation arise from a single, unified framework that is firmly rooted in neoclassical microeconomic theory. This, in turn, allow us to demonstrate that the corporate valuation approach generically known as real options analysis is perfectly justifiable – without further qualification – in any situation when investors want managers to maximize NPV.

Key words: NPV, real options analysis, arbitrage, fundamental theorem of asset pricing

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Some Important Issues Involving Real Options: An Overview
(Multinational Finance Journal, 2010, vol. 14, no. 1/2, pp. 73–123)

Gordon Sick
University of Calgary, Canada
Andrea Gamba
University of Verona, Italy

This paper provides an introduction to real options, as well as highlighting some important issues that are often neglected by real options analysts. While many books and surveys have been written on real options, there are some ubiquitous concepts that are not well-understood by many authors and practitioners. The objective of this paper is to redress this shortfall. The paper discusses organizational issues that impede adoption of real options strategies. It discusses modeling and analytic techniques for real options. (JEL: C61, D92, G31)

Keywords: Real Options, Capital Budgeting, Numerical Methods

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Flexibility and Games in Strategic Investment
(Multinational Finance Journal, 2010, vol. 14, no. 1/2, pp. 125–151)

Han T.J. Smit
Erasmus University Rotterdam, Netherlands
Lenos Trigeorgis
University of Cyprus, Cyprus

We present a framework for value-based strategic planning combining concepts and tools from strategy and finance. Our ‘Expanded NPV’ framework reconciles flexibility and strategic commitment, viewing strategic planning as managing a portfolio of real options with competitive interactions. The flexibility and strategic value of a business strategy are interwoven with that strategy’s design. We synthesize real options and game theory to evaluate projects or acquisitions. We connect strategic planning and the underlying sources of value creation with the market value of the firm and its three main value components: expected cash flows or assets in place (NPV), flexibility (growth options), and strategic value (moves and games). We develop implications depending on simple or compound growth options, the type and competitive impact of the investment, and relative market power.

Keywords: strategic planning, real options, game theory, option games, competition.

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