Reconciling Discounted Cash Flow and Real Option
Valuations
Whydoesaninvestmentsometimeshavehighervaluewhen
wevalueitusingreal-optionapproachesthanwithtraditional
discounted cash flow models? The answer lies in the
flexibilitythatfirmshavetochangethewaytheydobusiness,
based on what they observe in the market. Thus, an oil
companywillnotproducethesameamountofoilordrillas
manynewwellsifoilpricesfallto$35abarrelasitwouldif
oil prices go up to $75 a barrel.
In traditional net present value, we consider the expected
actionsandthecash flowconsequencesofthoseactionsto
estimatethevalueofaninvestment.Ifthereisapotentialfor
further investments, expansion, or abandonment down the
roadforafirm,allwecandoisconsidertheprobabilitiesof
suchactionsandbuilditintoourcashflows.Analystsoften
allowforflexibilitybyusingdecisiontreesandmappingout
theoptimalpath,giveneachoutcome.Wecanthenestimate
the value of a firm today using the probabilities of each
branchand estimating the presentvalue ofthe cash flows
from each branch.
Adecision treedoes beara significantresemblance to the
binomialtreeapproachthatweusetovaluerealoptions,but
therearetwodifferences.Thefirstisthattheprobabilitiesof
theoutcomesarenotuseddirectlyto valuetherealoption,
and thesecondis thatwehaveonly two branchesateach
node inthebinomialtree.Notwithstanding this,you might
wonderwhythetwoapproacheswillyielddifferentvaluesfor
theproject.Theanswerissurprisingly simple.Itliesinthe
discountrateassumptionswemaketocomputethevalue.In