The Option Value of Uncertain Projects
The Option Value of Uncertain Projects
This chapter first illustrates the notion of an option value with a simple numerical example, before examining a more sophisticated application with a Poisson two-armed bandit. In the first case, there is an option value to wait. In the second case, there is an option value to experiment. The theory of real option value has the objective to adjust the standard cost-benefit methodology, which is static by nature, in order to integrate these dynamic aspects of the evaluation problem. The computation of option values must be done by backward induction. At each node of the decision tree, the optimal decision is made by taking into account the optimal decisions in the subsequent nodes of that part of the tree.
Keywords: option value, uncertain projects, Poisson two-armed bandit, backward induction, risk management, net present values, NPV
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