A Tutorial for Modeling Real Options Lattices from Project Cash Flows

Abstract

Context: several methods for evaluating real options have been extensively studied and published. But recombining binomial trees, known as lattices, are perhaps one of the most practical and intuitive approaches to model uncertainty and price project managerial flexibilities for real options applications. Although the Cox, Ross, and Rubinstein (1979) lattice model is simple to implement for financial options, modeling real options lattices requires a different approach such as the one proposed by Copeland and Antikarov (2001), which considers project cash flows as dividends in the lattice model. Objective: in this tutorial, we propose a code in an open-source software with intuitive guidelines to help researchers and practitioners model real options lattices from project cash flows. Method: our code considers the correct project’s volatility estimation, dividend yield modeling, and lattice building. Results: the results show how real options can affect the value of projects. Conclusions: as a contribution, this tutorial provides a simple mechanism for analyzing investment opportunities in projects that have uncertainty and flexibility.

Keywords

• tutorial
• real options
• lattice model
• project volatility
• cash flow