Cash flow estimation for real option analysis using Margrabe's model

Andor, György and Bóta, Gábor (2006) Cash flow estimation for real option analysis using Margrabe's model. Acta Oeconomica, 56 (2). pp. 183-194. ISSN 0001-6373

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Abstract

This paper looks at how the parameters for real option analysis can be extracted from the general capital budget of a project and discusses how the estimated cash flows of a general project can be used for a real option analysis. A project is described where it is possible to stop the business operation in case of predicting a loss for the next year. Our model shows how the cash flow of the period influenced by the option-like decision has to be separated in order to get the exercise price and the price of the underlying asset for real option valuation. Besides providing arguments against the suitability of the general Black-Scholes formula for real option situations, the paper also shows how Margrabe's exchange option valuation formula may be used, and how the volatility as a parameter of this model can be calculated from the data available about the project.

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