Combining Real Options and Decision Tree

Abstract

Projects are inherently risky ventures because of their exposure to both market risks and project complexities. Project decisions need to be optimum not only at the time of decision making but also in respect of future stages and available project options. Because of the growth in project complexity coupled with market volatility, the traditional methods of project appraisal are no longer adequate; they fail to respond to the dynamic situations that often prevail in the development of risky and complex projects. The authors present an approach that combines real options theory with decision tree analysis to properly evaluate a project facing uncertainties. This technique is based on mapping all the available options on a given project and incorporating market uncertainties. For a given project, a real options value, adjusted by the implementation uncertainties at a time during its progress or at its initial stage, is estimated and added to the net present value of the project—the latter computed under uncertain conditions. The adjusted net present value can account properly for the risks a project may face, while counting in the value that proactive management may bring about. A simple numerical example is included to demonstrate the application of this technique.