Valuing Real Capital Investments Using The Least-Squares Monte Carlo Method

Abstract

The recently developed least-squares Monte Carlo (LSM) method provides a simple and efficient technique for valuing American-type options. The proposed method is applicable to the cases of compound real options, like the other numerical techniques such as finite difference and lattice methods, with the additional advantage to handle easily the cases of multiple uncertain state variables with different and complex stochastic processes. With this advantage, the LSM method is not only efficient for valuing multi-factor American options, but it can also be extended for valuing complex real investments having many embedded real options and involving multiple uncertain state variables. This article examines the applicability of the LSM method in valuing real capital investments. Two valuation examples have been provided to test the efficiency of the proposed method in both the valuation and the decision-making processes.