Abstract
AbstractNPV, decision trees, and real options have been prevalently practiced in real asset valuation and management. Complexities have been built on the basic frameworks in practice. In this paper, application values and limitations of real options, NPV, and decision trees in real asset valuation are illustrated with literature review. The pros and cons of each method shed light on future improvement of real asset investment evaluation and risk modeling.
Highlights
Unlike Net Present Valuation (NPV), decision trees focus on modeling various kinds of flexibilities during a life span of a technology project development
Hull’s book on derivative pricing has been highly recognized and accepted as a classical textbook for derivatives over years. He added a new chapter of real options in the new version (2003) textbook, in which the theoretical framework of real option modeling is described as: “...We find that an asset can always be valued as if the world were risk neutral, provided that the expected growth rate of each underlying variable is assumed to be risk free rate
For traded assets in equilibrium or for real assets with no systematic risk (e.g. R&D and exploration or drilling for certain precious metals or natural resources), the certainty-equivalent or risk-neutral growth rate just equals the risk-free interest rate” (Trigeorgis, 1996). In summary of his opinions, one of the following rationales must be true in order to support the validity of the extensively used ‘risk neutrality’ approach in real option pricing: a, the “portfolio matching” or “twin portfolio”, i.e. the underlying asset distribution can be “perfectly” mimicked by a financial security; b, the complete market theory, which includes the real asset investment into the financial asset market
Summary
Unlike NPV, decision trees focus on modeling various kinds of flexibilities during a life span of a technology project development. If the investment falls into the latter, decision trees with the estimated real probabilities is proper In his model, he claimed the amount of the gas discovered has private risk and the price of gas has market risk. Integrating the risk neutral valuation and specific risk valuation, according to Borison (2003), is a “consistent and reasonably accurate world-view” to price option in the real asset investment. His approach became inconsistent when he applied real probabilities of gas amount and risk free rate of return simultaneously as pointed by Trigeorgis (1996). The binomial tree constructed by Borison demonstrated the challenges to integrate both with theoretical soundness and practical feasibility, as Boer (2002) stated in his “financial management o R&D 2002”, “the distinction between unique and market risk is critical for sound decision-making in real business.”
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