Reconciling Real Option Models: An Approach to Incorporate Market and Private Uncertainties

Several real options analysis techniques designed for practitioners exist in literature, but there is discrepancy in their underlying assumptions, mechanics and applicability. Within this paper, a review of approaches targeted towards practitioners is included, and a novel way of integrating market and private uncertainties is proposed. Market risk is incorporated into the dynamics of the project cash flow by assuming the success of the project is correlated to a traded index. The value of the real option on the project cash flows may be priced by traditional numerical methods or a simulation approach similar to the previously recommended Datar-Mathews method (Datar et al., 2007). A numerical example presents the proposed model within the simulation framework.