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Risk-adjusted valuation for real option decisions

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journal contribution
posted on 2023-06-10, 01:00 authored by Carol AlexanderCarol Alexander, Xi ChenXi Chen, Charles Ward
We model investor heterogeneity using different required returns on an investment and evaluate the impact on the valuation of an investment. By assuming no disagreement on the cash flows, we emphasize how risk preferences in particular, but also the costs of capital, influence a subjective evaluation of the decision to invest now or retain the option to invest in future. We propose a risk-adjusted valuation model to facilitate investors’ subjective decision making, in response to the market valuation of an investment opportunity. The investor’s subjective assessment arises from their perceived misvaluation of the investment by the market, so projected cash flows are discounted using two different rates representing the investor’s and the market’s view. This liberates our model from perfect or imperfect hedging assumptions and instead, we are able to illustrate the hedging effect on the real option value when perceptions of risk premia diverge. During crises periods, delaying an investment becomes more valuable as the idiosyncratic risk of future cash flows increases, but the decision-maker may rush to invest too quickly when the risk level is exceptionally high. Our model verifies features established by classical real-option valuation models and provides many new insights about the importance of modelling divergences in decision-makers risk premia, especially during crisis periods. It also has many practical advantages because it requires no more parameter inputs than basic discounted cash flow approaches, such as the marketed asset disclaimer method, but the outputs are much richer. They allow for complex interactions between cost and revenue uncertainties as well as an easy exploration of the effects of hedgeable and un-hedgeable risks on the real option value. Furthermore, we provide fully-adjustable Python code in which all parameter values can be chosen by the user.

History

Publication status

  • Published

File Version

  • Accepted version

Journal

Journal of Economic Behavior and Organization

ISSN

0167-2681

Publisher

Elsevier

Volume

191

Page range

1046-1064

Department affiliated with

  • Accounting and Finance Publications

Full text available

  • Yes

Peer reviewed?

  • Yes

Legacy Posted Date

2021-09-17

First Open Access (FOA) Date

2023-04-25

First Compliant Deposit (FCD) Date

2021-09-17

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