Decision Analysis
Vol. 2, No. 2, June 2005, pp. 69–88
issn 1545-8490 eissn 1545-8504 05 0202 0069
informs®
doi 10.1287/deca.1050.0040
©2005 INFORMS
Using Binomial Decision Trees to Solve
Real-Option Valuation Problems
Luiz E. Brandão
IAG Business School,https://www.51lunwen.org/StudentPapers.html Pontifícia Universidade Católica do Rio de Janeiro, Rio de Janeiro, RJ 22453-900, Brazil,
brandao@iag.puc-rio.br
James S. Dyer, Warren J. Hahn
McCombs School of Business, The University of Texas at Austin, Austin, Texas 78712
{jim.dyer@mccombs.utexas.edu, warren.hahn@phd.mccombs.utexas.edu}
Traditional decision analysis methods can provide an intuitive approach to valuing projects with managerial
flexibility or real options. The discrete-time approach to real-option valuation has typically been implemented
in the finance literature using a binomial lattice framework. Instead, we use a binomial decision tree
with risk-neutral probabilities to approximate the uncertainty associated with the changes in the value of a
project over time. Both methods are based on the same principles, but we use dynamic programming to solve
the binomial decision tree, thereby providing a computationally intensive but simpler and more intuitive solution.
This approach also provides greater flexibility in the modeling of problems, including the ability to include
multiple underlying uncertainties and concurrent options with complex payoff characteristics.
Key words: decision analysis; real options; decision trees; binary approximations
History: Received on September 15, 2004. Accepted by Robert Clemen and Don Kleinmuntz on May 25, 2005,
after 2 revisions.
1. Introduction
Discounted cash flow (DCF) methods are commonly
used for the valuation of projects and for decision
making regarding investments in real assets. One of
the most important limitations of DCF is that it fails to
account for the value of managerial flexibility inherent
in many types of projects. The options derived
from managerial flexibility are commonly called “real
options” to reflect their association with real assets
rather than with financial assets. Although appealing
from a theoretical perspective, the practical use of
real-option valuation techniques in industry has been
limited by the mathematical complexity of these techniques
and the resulting lack of intuition associated
with the solution process, or the restrictive assumptions
required to obtain analytical solutions.
In this article we outline how traditional decision
analysis tools can be used as an alternative to solve
real-option valuation problems based on the ideas
suggested by Copeland and Antikarov (2001) and further
illustrated in Copeland and Tufano (2004). We do
this by using a binomial decision tree to determine
the cash flows and probabilities that give the correct
project values when discounted to each period
and to each uncertain state. Project flexibilities, or real
options, can then be modeled easily as decisions that
affect these cash flows. This specification of project
uncertainties, cash flows, and decisions allows the
problem to be modeled and solved using commercially
available decision tree software familiar to the
decision analysis community. Our discussion expands
on the ideas presented originally by Brandão and
Dyer (
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