A General Approach to Real Option Valuation with ... - ICMA Centre

ICMA Centre Discussion Papers in Finance DP2012-04price falls next year, and since the asset is currently valued at $1m, the value of this decisionopportunity is 5, 853 after accounting for the cost of capital to purchase the property.Now consider the equivalent problem from the perspective of the current owner of theasset. 15 We suppose this potential seller has the same views on market prices as the potentialinvestor, and the same utility and borrowing/lending costs. Figure 2 depicts the decisiontree for the divest option. The action S denotes ‘sell the property’ and the action R denotes‘remain invested’. To obtain the present value of the P&L arising from selling the asset atany time in future, we subtract its current value p 0 from the forward market price, assumingthe asset is currently financed by borrowing funds.Figure 2: Illustration of the divest real option, including optimal decision at each node with S= ‘sell’ and R = ‘remain’, discounted market prices in black and expected utilities for backwardinduction in blue. Decision opportunities every year for three years. r =5%,μ = 10%, σ = 20%.Exponential utility with λ =0.4.If the owner sells the property the market price at that time is realised and there is nofuture uncertainty. But if he remains the owner of the property, further decision nodes occur15 We use the term ‘equivalent’ to refer to the invest and divest options that are based on the same priceand decision processes, for decision makers with identical utilities. Note that if it is optimal for the investorto exercise his option at t = 0 and for the divestor of the equivalent option never to exercise, their pay-offdistributions become identical and hence the two options have the same value – see XXX for an example.Copyright c○ 2012 Alexander and Chen 18