A binomial tree valuation approach for compound real options with fuzzy phase-specific volatility

Abstract

Real options analysis (ROA) is an approach for evaluating investment and strategic projects. And it helps manager in making decisions in an uncertain and highly competitive business environment. In contrast with common discounted cash flow (DCF) approaches, ROA is capable of taking strategic flexibilities and managerial innovations into account. ROA is in fact using the concept of financial options in the process of decision making. In this paper, I have developed an intuitive and practical method for evaluating multistage strategic or investment projects. A specific volatility is assigned to each phase of the project, and is estimated in a fuzzy framework by exploiting data from previous similar projects and experts' knowledge. Then, these fuzzy volatilities are included in the multistage binomial tree valuation model. At the end, the presented model is implemented on an example R&D project. The advantage of my model is that it can be easily extended to involve various types of options embedded in multistage projects.