Real options valuation

Managerial flexibility has value. The ability of their managers to make smart decisions in the face of volatile market and technological conditions is essential for firms in any competitive industry. This advanced tutorial describes the use of Monte Carlo simulation and stochastic optimization for the valuation of real options that arise from the abilities of managers to influence the cash flows of the projects under their control. Option pricing theory supplements discounted cash flow methods of valuation by considering managerial flexibility. Managers' options to take actions that affect real investment projects are comparable to options on the sale or purchase of financial assets. Just as a financial option derives much of its value from the potential price movements of the underlying financial asset, a real option derives much of its value from the potential fluctuations of the cash flows generating the value of the investment project.