Realistic investment valuation: a comprehensive real options model

Abstract

Purpose – The purpose of this paper is to present the developed real options analysis framework and outline how it complements the traditional investment valuation approach – discounted cash flow model. While real options analysis has gained both professional and academic interest in recent years, Latvian companies are seemingly lagging behind in its application. The framework is intended to demystify real options, demonstrate practical benefit of this theory and is explained in process of investment valuation of a selected logging industry enterprise in Latvia.

Design/methodology/approach – The research is defined as descriptive in its purpose, quantitative in its approach, deductive in its logic and applied as of its outcome. Investigation of the issue is carried out in a non-contrived setting with minimal researcher’s interference. Secondary sources of data are used to provide theoretical basis for the framework, while primary data, obtained from entity’s representatives during several unstructured interviews, is applied to solve the real options problem addressed in the practical part of the paper.

Findings – The developed real options analysis framework can be successfully applied in solving a real options problem. During valuation of the selected enterprise’s real options portfolio, which comprises of deferral, expansion, contraction and switching options, real options portfolio value present value is calculated as 28 246 LVL. If decision to realize either real option is deferred, real options increase net present value of cash flows by 5.55%. By this amount entity management has augmented its investment’s value with the introduction of the framework in its capital budgeting process.

Practical implications – Developed real options analysis framework can be used for real options valuation in both academic and professional environments. Model can also be used as a learning tool by those, who seek insight into real options theory.