An Assessment of the Option to Reduce the Investment in a Project by the Binomial Pricing Model

Salvador Cruz Rambaud, Ana María Sánchez Pérez

Abstract


Real options are a powerful complement to traditional methods of investment project assessment, such as the Net Present Value, when the value of some business strategies has to be included. This paper presents a methodology to calculate the value of the real option to reduce an investment project within one, two, and n periods. It is well known that the option to reduce quantifies the value of the operational flexibility available to protect a business against possible losses generated by the project. Thus, to derive its value, the procedure implemented here consists in obtaining a mathematical expression for each of the aforementioned periods, based on a detailed construction of every possible future scenario and its associated probability by the multiplicative binomial method.

DOI: http://dx.doi.org/10.5755/j01.ee.28.5.17636


Keywords


Real option; option to reduce; binomial pricing model; investment project assessment; financial engineering

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Print ISSN: 1392-2785
Online ISSN: 2029-5839