Real Options Valuation: a Monte Carlo Approach

This paper provides a new approach for valuing a wide set of capital budgeting problems with many embedded real options dependent on many state variables and a related valuation algorithm based on Monte Carlo simulation. The valuation approach decomposes of a complex real option problem with many options into a set of simple options, but taking into account deviations from value additivity due to interaction and strategical interdependence of the embedded real options, as noted by Trigeorgis (1993). The valuation approach presented in this paper is an alternative to the general switching approach for valuing complex option problems, as proposed by Kulatilaka and Trigeorgis (1994) and Kulatilaka (1995). The related numerical algorithm is based on simulation along the lines of Longstaff and Schwartz (2001) and is extended in order to implement the decomposition approach. We provide also an array of numerical results to show the convergence of the algorithm and a few real life capital budgeting problems, to see how they can be tackled with our approach. JEL Classification: C15, C63, G13, G31.