The Real Options Lattice: An Alternative to Discounted Cash Flow

Abstract

Real options methods determine value of a proposed project. In some ways, real options resemble the common net present value method; the net of expected future cash flows is discounted to the present (in today’s currency). For example, one would select projects with a projected net present value (NPV) greater than zero, when future cash flows exceed expenditures. When proposed projects are mutually exclusive, the highest NPV determines the winner. However, real options expand the traditional NPV formula and open up a wider range of choices. The tools of real options analysis include both discrete and continuous stochastic analysis, partial differential equations, Black-Scholes modeling, and decision trees. Of these methods, the lattice-type tree offers the simplest means to value and explain real options. This paper will demonstrate real options analysis using the recombining binomial lattice, and present a sample project scenario. (This is the original work of the authors and not previously published.)