Sensitivity Analysis for Cash Flow Simulation Based Real Option Valuation

Sensitivity analysis identifies the critical aspects of the investment model that affect model output uncertainty. Common sensitivity analysis on options considers how the solution changes as a result of change in one of the key parameters (underlying asset value, volatility, exercise price, interest rate, time to maturity, dividends). In case of cash flow simulation based real options, these are mostly indirect variables that are computed based on the primary input variables demand, unit selling price, and unit costs in the cash flow calculation. The method presented in this paper combines the uncertainties in the underlying asset together by simulation, and then uses regression analysis approach for estimating how a change in a primary variable or variables affects simultaneously the stochastic process parameters of expected value and volatility during different time periods. As a result, the presented method shows how a change in a primary variable affects project value with real options. This information is also essential as it shows decision makers which uncertainties to follow, and thus this mitigates the common black box syndrome of consolidated cash flow simulation based methods.