A lattice claims model for capital budgeting

Techniques of contingent claims analysis (CCA), extend current capital budgeting practices in two specific ways. First, by explicitly accounting for project uncertainty and second, by quantifying the flexibility value afforded due to the presence of real options. When applied appropriately, CCA techniques can provide a powerful and robust valuation approach and are particularly useful in providing insight to key strategic factors that affect project value. These advantages, however, come at some expense as most applications of CCA to project valuation result in complex partial differential equations which cannot be solved for simple analytic formulas. This, combined with the intricate mathematical structure of these methods often make it difficult for an intuitive grasping and may result in implementation problems. The purpose of this article is to provide a prefatory perspective on the use of CCA techniques as applied to engineering, production, mining, and manufacturing projects. To that end, by using efficient numerical techniques this article formulates a simple and unified CCA framework for valuing a large class of projects that contain real options. The approach is straightforward, readily implementable, and computationally efficient. The framework presented in this paper also provides an important introduction to the use of CCA methods and the quantification of flexibility value in the management of operations.<
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