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# Real Option Method in Evaluation of Long-Term Investment

Student: Irina Martyanova

Supervisor:

Educational Programme: Economics (Bachelor)

Year of Graduation: 2017

Real options models are fast becoming a key instrument to the valuation of investment attractiveness of the projects due to its capability to implement uncertainty into calculations of future cash flows. The main disadvantage of real option method is that it requires big data analysis and a strong mathematical background of knowledge in order for the calculations to be performed correctly. Therefore, the problem of defining the most correct and relatively simple way to measure investments attractiveness arises. The concept of valuating real options can be seen from two main perspectives – by implementing Black-Scholes formula or by constructing a binominal decision tree. First approach estimates the cost of the option using uncertainty parameters. While one method includes the volatility of the market and the foreseen changes of the market conditions into calculations, the other approach depicts the management flexibility during the whole project life-cycle – every investments are viewed individually taking into account the predicted market conditions, possible shifts in cash flows and other risk factors. Although these approaches have gained popularity, they still have some limitations (lognormal distribution, the continuity of time, etc.) that can seriously undermine their flexibility. «An intuitive algorithm for Black-Scholes formula» and «Boeing approach» are comparatively innovative methods of valuing project’s real options that introduce more simple algorithms for estimating investment’s effectiveness. This paper aims to provide theoretical background of existing real option evaluation models and analyze the flexibility of «An intuitive algorithm for Black-Scholes formula» and «Boeing approach» models by estimating the total project value of carbonate deposit development. As a result, the conclusions on the obtained options values and the differences between NPV and total project value were explained.

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