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

Chapter Six— Limitations and conclusion6.1 limitations6.1.1 For Option BIn the valuation of this compound option, some rough assumptions have been made.Firstly, the estimation of volatility. It assumes no dividends have been paid during thetime of the options. And the assumption is rather simple, as is assumes same volatilityover the life period of the option B. This could be problematic in the real world, as thevolatility may not be know and may change over the life of the option, which couldmake the option valuation very complex. More importantly, the valuation methodused may not be the best suitable one for this case, and Monte Carlo Simulation maybe a better way to estimate the volatility. Due to time constraints, however, a simplervaluation method was used. Secondly, the assumption of salvage value. The salvagevalue of option B is assumed to be related to their value for each underlying assetvalue, and the estimation of salvage value did not incorporate issues like inflation.And finally, for this ten year option, a binomial tree of only 5 steps has been used. Allthese assumptions could affect the accuracy of the result.6.1.2 For Option AFirstly, volatility. As explained earlier in this chapter, the volatility for Option A couldbe simulated, but an assumption of 70% was made. Although the sensitivity analysisspecifically addressed the impact of the change of volatility on real option values, thiscould still be one of the factors that influence the accuracy of option valuation.Secondly, risk-free rate for option A is assumed to be a single one, for the sake ofPage | 67