Valuing Real Options: Frequently Made Errors

Abstract

In this paper we analyze frequently made errors when valuing real options. The best way of doing it is through examples. We start by analyzing Damodaran's proposal to value the option to expand the business of Home Depot. Some of the errors and problems of this and other approaches are: - Assuming that the option is replicable and using Black and Scholes' formula. - The estimation of the option's volatility is arbitrary and has a decisive effect on the option's value. - As there is no riskless arbitrage, the value of the option to expand basically depends on expectations about future cash flows. However, Damodaran assumes that this parameter does not influence the option's value (he does not use it) because he assumes that the option is replicable. - It is not appropriate to discount the expected value of the cash flows at the risk-free rate (as is done implicitly when Black and Scholes' formula is used) because the uncertainty of costs and sales at the exercise date may be greater or less than that estimated today. - Damodaran's valuation assumes that we know exactly the exercise price. - Believing that options' value increases when interest rates increase. - "Playing" with volatility. - Valuing contracts as real options when they are not.