Real Options are concerned with expanding, delaying or abandoning a project or a business decision. A real option value depends on the expected value of the future cash flows. Important elements in real option valuation are the discount rate and the expected cash flows for various scenarios. Decision trees help in deciding the payoff for the options for different scenarios and thus help in deciding whether to exercise the option or not and when to exercise it (Bowman, and Moskowitz, 2001).
Decision trees can be single staged or multiple staged. The value of the options to be determined dictates the periodicity of the decision tree as well. The process of valuing the options start with deciding the scenarios when the option is either exercise or not. This is generally called the upward or the downward uptick (Brandao, Dyer, and Hahn, 2005).
The upward and downward movement in cash flows are then used to determine the probability of those scenarios occurring. Then the expected value of the option is found by multiplying the upward or downward tick with the probabilities for the scenarios. This expected value is after a time ‘t’ when the business decision is to be taken. To find the value of the option at current point in time, this expected value is discounted using the discount rate for the project. This discount rate is generally the marginal cost of capital for the company.
The primary advantage of using decision trees to value real options is that it provides information about the alternative options for the company and models it using different scenarios and the payoff for such scenarios. The business decision can then be taken after comprehensively reviewing all the alternate scenarios and considering the scenario which is best for the company (Bowman, and Moskowitz, 2001).
Also, business risks can be factored into the valuation through two ways. Firstly, the probabilities of various cash flow scenarios can be adjusted by taking into account risks associated with such possibilities. Further, the discount rate for the company has inherently factored in the risks associated with the project through cost of capital. This way, the company is able to capture risk adjusted value of the business decisions it intends to take.
However, there can be a number of disadvantages as well of using decision trees for valuing real options. The probabilities assigned to various scenarios takes into account certain subjective assumptions, which can distort the actual value of the options. Also, time lags and delays after business decision has been taken cannot be factored into the valuation model.
Further, a single stage or two stage models can be managed easily and can be refined from time to time to factor in additional information. However, for complex projects with long timelines, the trees can run into a lot of stages. This makes the process complex, time consuming and difficult to manage (Brandao, Dyer, and Hahn, 2005).
These decision tree models are generally used by big companies, financial analysts, hedge funds or asset management companies to value their investments. The purpose for which they are used can vary from one user to another (Bowman, and Moskowitz, 2001).
While companies with long, capital intensive projects may use decision trees to make sure that the project is profitable. On the other hand, financial analysts can use decision trees to track how the financial health of a company will be affected through various business decisions. Asset management or investment funds may use decision trees for valuing options of whether to invest in such projects or when to exit from such projects.
Reference List
Bowman, E. H., and Moskowitz G. T., 2001. Real options analysis and strategic decision making. Organization Science, 12, pp.772–777.
Brandao, L. E., Dyer J. S., and Hahn W. J., 2005. Using binomial decision trees to solve real-option valuation problems. Decision Analysis, 2, pp.69–88.
