# The Numerical Methods for Real Options

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Words: 5674

Date added: 17-06-26

**Type:** Analytical essay

**Category:** Finance Essay

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According to Mun(2006), Real Options(RO) is a " systematic and comprehensive method" used to value real tangible assets. The term "Real Options," first used by Myers(1977), refers to the application of financial options theory to investment decisions made by firms (Krychowski and QueÂ´lin, 2010). RO has been of growing interest to the academic community as a promising approach to supporting investment decisions under uncertainty. Pioneering scholars such as Trigeorgis(1996) and Copeland(2001), have contributed valuable work to topics on real options such as the RO value in resource allocation and capital budgeting. Generally speaking, there are three main methods which are used as the tools to value the embedded RO. They are the Black-Scholes Model, the Binomial Model and Monte Carlo Simulation. Each of the method requires certain assumptions and can be best applied under specific situations. On the empirical side, RO analysis has been applied widely in a range of industries such as pharmaceutical drug development, oil and gas exploration and production, and the like. Survey results of 4,000 CFOs published in 2001 by Graham and Harvey revealed that 27% of the respondents claimed they "always or almost always" used some kind of options approach to evaluating and deciding upon growth opportunities (Copeland & Tufano, 2004). Compared with the traditional discounted cash flow methods which assumed that the future cash flows can be discounted by a single fixed rate, RO analysis enjoys the merit of being highly flexible because it incorporates the managers' ability to actively respond to the unfolded uncertainties. It is noted by Hall (2005) that around 30 percent of the values of high-growth, high volatility firms come from the value of embedded options. Primarily motivated by the usefulness of RO, after doing a general research on its background, I did further reading on approaches employed to value the embedded options. In this paper, my work can be divided into three parts. In the first section, a background on the real option analysis is presented. This includes an overview of typical categories of RO, the classical methods employed to value the RO and also the industrial practices of applying the RO Analysis. Additionally, a brief comparison between the traditional methods and RO is also presented. In the second section, I demonstrate the three methods in detail with elaboration on their assumptions and steps of analysis, as well as examples of application. In the final section, I conclude with a discussion of these numerical methods, including their merits and limitations as well as responses to some of the critics that RO analysis has incurred. I hope that this paper could serve as a motivator for further research.

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