Implementing Real Options Valuation under Macroeconomic Risk and Normally Distributed Cash Flows

Authors : Norvald Instefjord, Turalay Kenç

Pages : 50-67

Doi:10.33818/ier.1476515

View : 8 | Download : 11

Publication Date : 2024-09-16

Article Type : Research

Abstract :The paper highlights the encountered problems in implementing real options under more realistic assumptions such as business cycle risk and normally distributed cash flows. The problems considered include (i) estimating empirical distribution of cash flows from real option investments; (ii) investment decisions across business cycles, and (iii) calculating the probability of investing with the above stated rich features. To this end, we estimate operating cash flows of US corporate firms using a Markov chain model under both geometric and arithmetic Brownian motions assumptions for cash flows and develop a valuation model of real option with normally distributed cash flows. Associated investment valuation models incorporating these estimates reveal that critical cash flow levels significantly differ across models and regimes.
Keywords : Macroeconomic Risk, Regime Switching, Real Options, Arithmetic Brownian Motion, Geometric Brownian Motion