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Risk-adjusted Valuation of the Real Option to Invest

This paper resolves the conceptual ambiguity of real option value and derives a model using risk-adjusted discount rates that can be applied to value the option to invest in a project. The approach adopts stochastic revenue and costs which provide a general solution with the added virtue of applicability. We found the option value arises from the difference between an individual investor and the market in financing efficiency and risk preferences. Investors’ taking on idiosyncratic risks are crucial to obtaining the real option value; hedging project risks can significantly reduce the associated real option value.

Published on 15th December 2014
Authors Professor Charles Ward
Series Reference ICM-2014-19