Academic journal article International Journal of Business

Real Options Valuation within Information Uncertainty: Some Extensions and New Results

Academic journal article International Journal of Business

Real Options Valuation within Information Uncertainty: Some Extensions and New Results

Article excerpt

ABSTRACT

This paper develops some results regarding the economic value added and real options. We use Merton's (1987) model of capital market equilibrium with incomplete information to introduce information costs in the pricing of real assets. This model allows a new definition of the cost of capital in the presence of information uncertainty. Using the methodology in Bellalah (2001, 2002) for the pricing of real options, we extend the standard models to account for shadow costs of incomplete information.

JEL Classification: G12, G20, G31

Keywords: EVA; Real options; Information costs

I. INTRODUCTION

Over the last two decades, a body of academic research takes the methodology used in financial option pricing and applies it to real options in what is well known as real options theory. This approach recognizes the importance of flexibility in business activities. Today, options are worth more than ever because of the new realities of the actual economy: information intensity, instantaneous communications, high volatility, etc.

Financial models based on complete information might be inadequate to capture the complexity of rationality in action. As shown in Merton (1987), the "true" discounting rate for future risky cash flows must be coherent with his simple model of capital market equilibrium with incomplete information. This model can be used in the valuation of real assets (1).

Managers are interested not only in real options, but also in the latest outgrowth in DCF analysis; the Economic Value Added. EVA simply means that the company is earning more than its cost of capital on its projects. EVA is powerful in focusing senior management attention on shareholder value. Its main message concerns whether the company is earning more than the cost of capital. It says nothing about the future and on the way the companies can capitalize on different contingencies. Hence, a useful criterion must account for both the DCF analysis and real options. The NPV and the EP (economic profit) ignore the complex decision process in capital investment. In fact, business decisions are in general implemented through deferral, abandonment, expansion or in series of stages. This paper accounts for the effects of information costs in the valuation of derivatives as in Bellalah (2001).

The structure of the paper is as follows. Section II presents a simple framework for the valuation of the firm and its assets using the concept of economic value added in the presence of information costs. Section III develops a simple analysis for the valuation of real options within information uncertainty. Section IV develops a context for the pricing of real options in a continuous-time setting using Standard and complex options. In particular, we extend the model in Triantis and Hodder (1990) for the valuation of flexibility as a complex option within information uncertainty. Section V develops some simple models for the pricing of real options in a discrete time setting by accounting for the role of shadow costs of incomplete information. We first extend the Cox, Ross and Rubinstein (1979) model to account for information costs. Then, we use the generalization in Trigeorgis (1990) for the pricing of several complex investment opportunities with embedded real options.

II. FIRM VALUATION UNDER INCOMPLETE INFORMATION

We remind first Merton's (1987) model and the definition of the shadow costs of incomplete information.

A. Merton's model

Merton's model may be stated as follows:

[bar.Rs] - R = [[beta].sub.s][[bar.R].sub.m] - R] + [[lambda].sub.s] - [[beta].sub.s][[lambda].sub.m]

where [[bar.R].sub.s]: the equilibrium expected return on security S; [[bar.R].sub.m]: the equilibrium expected return on the market portfolio; R: one plus the riskless rate of interest, r; [beta] = cov([bar.R]s/[bar.R]m)/Var([bar.R]m): The beta of security S; [[lambda]. …

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