application of real options valuation to r&d investments in ...

delayed in time. Undertaking one project may rule out other superior projects anditself at some later data, thus trading off the instant value by exercising the projecttoday against the opportunity of future project gains.But it does not necessarily mean that real options valuation methods can replace NPVor DCF methods. This is because to use real option valuation methods, the value ofthe underlying asset has to be calculated, and DCF is typically used for value that.Moreover, DCF is useful for safe cash flows, where there is less uncertainty. In all,real options valuation method offers a better way of capturing the value of flexibility,and DCF method can be viewed as the base model of real options method when thereis no possibility of calculating of the value of the flexibility of the project, argued byNewton, Paxson and Widdicks (2004).2.2.3 Advantages over decision trees methodThe real options approach offers several advantages over decision trees method.Firstly, although decision trees method is useful for modeling the possible outcomesthat associated with uncertain subsequent activities in a project and evaluate allalternative actions managers can take, the decision trees method is discrete in time(Bode-Greuel, 2000). In contrast, options analysis is continuous.Secondly, decision trees analysis will not give the correct value for options because itis not a risk neutral analysis. As indicated by Bode-Greuel (2000), decision treesmethod is a model of decision makers‘ individual attitude toward risk because theymake subjective judgment which is based on the characteristics of utility function.Although the expected PV of a project is computed by assuming that decision makeris risk-neutral in decision trees analysis, probability is determined by the informationavailable at the time when decision maker doing analysis. This implies that thedecision makers are analyzing projects in accordance with their risk attitudes, i.e. thedegree of risk-seeking or risk-averse. Conversely, real options analysis assumes arisk-neutral world, where probability assessment is not depended on decision makers‘Page | 15