Introducing a real option framework for EVA/MVA analysis

Abstract

The importance of including real option analysis (ROA) in traditional net present value (NPV) analysis has been demonstrated in the literature: ROA values the flexibility to defer, expand, contract, or abandon an investment project, allowing for dynamic decision making. However, methods to apply ROA for firms that utilize economic value added (EVA) and market value added (MVA) for project valuation purposes are not available. This article presents a novel framework that allows for an EVA/MVA analysis to be incorporated into a binomial tree option pricing model. This new EVA/MVA-embedded binomial tree framework not only allows for the consideration of real managerial options within EVA/MVA analysis but also demonstrates its equivalence to the traditional ROA used to adjust NPV. The benefits of this development are that EVA/MVA with an embedded binomial tree is deemed to be an equally valid and robust technique to traditional NPV analysis as opposed to simply being viewed as an alternative or competing measure of project value. This further validates the choice of some firms’ use of EVA/MVA and shows that strategic ROA can be incorporated into corporate decision making.