Abstract
This paper provides an overview of numerical methods and its applicability for solving real option problems. It discusses alternative approaches and shows that both forward and backward induction procedures have a place in real options valuation. A case-project with the option of investing in the future contingent on a stochastic output price is valued using binomial trees, finite differences, and simulation. The Black and Scholes (1973) analytical solution to this problem is used as a benchmark. All four methods provide similar results. The extension of simulation methods to American-Type options is discussed and a solution to Brennan and Schwartz's (1985) classic mine valuation problem is presented. The benefits of this approach, with its better handling of complex uncertainty modeling and path-dependent cash flows, are discussed.
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