A Closed-Form Model for Valuing Real Options Using Managerial Cash-Flow Estimates

In this work, we build on a previous real options approach that utilizes managerial cash-flow estimates to value early stage project investments. Through a simplifying assumption, where we assume that the managerial cash-flow estimates are normally distributed, we derive a closedform solution to the real option problem. The model is developed through the introduction of a market sector indicator, which is assumed to be correlated to a tradeable market index, which drives the project’s sales estimates. Another indicator, assumed partially correlated to the sales indicator drives the gross margin percent estimates. In this way we can model a cash-flow process that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash-flow in a financially consistent manner under the risk-neutral minimum martingale measure. The method requires minimal subjective input of model parameters and is very easy to implement. We also investigate the sensitivity of the normal distribution assumption by comparing the approach developed here to our previous approach.