Model risk in real option valuation

We introduce a general decision-tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in the assumptions made by standard real option valuation methods. We examine how real option values depend on the dynamics of project value and investment costs, the frequency of exercise opportunities, the size of the project relative to initial wealth, the investor's risk tolerance (and how it changes with wealth) and several other choices about model structure. For instance, contrary to stylised facts from previous literature, real option values can actually decrease with the volatility of the underlying project value and increase with investment costs. And large projects can be more or less attractive than small projects (ceteris paribus) depending on the risk tolerance of the investor, how this changes with wealth, and the structure of costs to invest in the project.

Automated summary

This study introduces a general decision-tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in standard real option valuation methods. The research examines how real option values depend on various factors including project dynamics, investment costs, exercise opportunities, project size relative to initial wealth, and investor's risk tolerance. Contrary to previous literature, it is found that real option values can decrease with project volatility and increase with investment costs, and the attractiveness of large projects compared to small projects depends on investor risk tolerance, changes in risk tolerance with wealth, and cost structures to invest in the project.