Abstract
Although the academic literature on real options has grown enormously over the past three decades, hitherto an accurate real option pricing model has not been developed for investment decision analyses. In this paper, we propose a real option pricing model based on sunk cost characteristics, which can estimate the value of real options more accurately. First, we explore the distinctive features that distinguish real options from financial options. The study shows that the distinguishing feature of the real options is the sunk cost, which does not exist in the financial options. Based on the sunk cost characteristic of real options, we find that the exercise conditions of real and financial options are different. Second, we introduce the sunk cost into the intrinsic value function of real options and establish a new real option pricing model. Finally, this paper also discusses the properties of the intrinsic value function and pricing model of real options. We find that the application of the Black–Scholes option pricing model will overestimate the value of real options.
Highlights
In this paper, we discuss the essential difference between real options and financial options and modify the financial option pricing model to account for the sunk cost
We find the difference mainly lies in the presence of the sunk cost in the exercise price of the real options, a quantity that does not enter in the strike price of the financial options. erefore, it is necessary to take the sunk cost feature of the initial investment into account when evaluating the value of real options by determining the conditions for executing or abandoning the real options
Conclusion and Discussion is paper discusses the essential differences between real options and financial options, including the sunk cost feature in the real option’s exercise price
Summary
Consider that the exercise price of the real options is the initial investment in, for example, manpower, material, and financial resources, all of which contain the sunk cost, compared to a fixed price that is stipulated in a financial option contract, which contains no sunk cost. Is situation shows that the enterprise is willing to incur large costs for obtaining technical capabilities only to avoid being surpassed by the competitors In such cases, the investment project must have a negative option value. For real options, the formation of exercise price needs an investment and construction process, and the realization of project value needs a production process, which is different from that of financial options. To overcome the problem of future price variability, one may have to use the average of past prices to substitute the future overall price, which introduces additional uncertainty into the analysis
Sign-in/Register to view highlights & summary Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
