Using the WACC to Value Real Options

We thank the editor and an anonymous referee. Any errors are our own. Abstract Using the WACC to Value Real Options We present a real option valuation using the weighted average cost of capital (WACC). This is an alternative to risk-neutral real option valuation. Using the WACC involves a marginal increase in mathematical complexity, but it is easy to implement in a spreadsheet, and it is easy to present to management. Our analysis reveals, however, that because the real option valuation is immune to choices of admissible discount rates (as per Arnold and Crack 2003a), the critical issue is correct estimation of volatility, not choice of discount rate. We also point out that the natural and conservative tendency to overestimate risk is anything but conservative in a real option valuation. 2 " As we go forward in time through the tree (binomial tree for pricing options), the outcome changes at each node. Because of this, however, the discount rate should also change. In real options, the correct discount rate is determined through the 'risk neutral' valuation. When I discuss real options internally, often the initial response is that it's nothing new. Explaining why it is – because it gets the discount rate right – is not simple, yet it is clearly very important in determining the correct valuation. This problem is exacerbated because most people are given a discount rate by the Treasury group for all calculations, and in general do not question its appropriateness. " John Stonier, Airbus Industrie from Chapter 2 of Copeland and Antikarov (2001)