Real options analysis as a practical tool for capital budgeting

Abstract

Purpose

This paper aims to demonstrate the practical application of real options analysis to the evaluation of multistage projects, using an example involving a commercial real estate development.

Design/methodology/approach

The approach demonstrated builds on static discounted cash flow (DCF) analysis and requires knowledge of only the binomial option pricing model.

Findings

Real options analysis can be implemented in a spreadsheet and only one parameter – the volatility of the price of the completed project – needs to be estimated in addition to those required for static DCF analysis. The approach described can be used to evaluate a project at any stage of development, which is especially useful when the suspension of partly completed projects is under consideration.

Originality/value

The paper shows how to carry out real options analysis of complex multistage development projects using straightforward valuation tools, making an important project evaluation technique more readily available to practitioners.

Citation

Guthrie, G. (2013), "Real options analysis as a practical tool for capital budgeting", Pacific Accounting Review, Vol. 25 No. 3, pp. 259-277. https://doi.org/10.1108/PAR-10-2013-0095