A real option approach for investment opportunity valuation

Abstract

In this paper, the valuation of an investment opportunity in a high-tech corporation using real option theory and modern capital budgeting is studied. Some key characteristics such as high-risk, multi-stage and technology life cycle of a high-tech project are considered in the proposed model. Since a real option is usually not tradable in the market, an actuarial approach is adopted in our study. We employ an irreversible regime-switching Markov chain to model the multi-stage and technology life cycle of the project in the high-tech industry. The valuation of captured real option can be formulated as the valuation of an American option with time-dependent strike price. For the purpose of practical implementation, a novel lattice-based method is developed to value the American option. Numerical examples are given to illustrate the proposed models and methods.