An Assessment of the Option to Reduce the Investment in a Project by the Binomial Pricing Model
Keywords:Real option, option to reduce, binomial pricing model, investment project assessment, financial engineering
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.