Enhanced MAD for Real Option Valuation and the Application of Market Utility A Case Study of Abandonment Option

In sharp contrast to the dominant real option valuation that assumes a stochastic process for an investment’s capital value, this paper demonstrates the valuation of a real option assuming that cash flow follows a stochastic process. We show that this method is at least equally effective and sometimes more intuitive. We note that, in a discounted cash flow (DCF) framework, only when certain constraints are met, assuming capital value as a geometric Brownian motion (GBM) is compatible with simultaneously assuming cash flow as a GBM; otherwise, making both assumptions in the valuation would lead to an incorrect real option value. We clarify the above argument with a simple textbook-standard case study. We further extend the traditional valuation approach using a market utility, which we illustrate in the same case study. We show that it provides a simpler valuation process and in particular, overcomes the challenge of changing the measure in traditional approaches. We further argue that this approach provides more flexibility and a clearer rationale for individual investors in their decision making.