Using Binomial Decision Trees and Real Options Theory to Evaluate System Dynamics Models of Risky Projects

Many important risky projects are characterized by stochastic processes embedded in non-linear, feedback structures with delays. System dynamics models may be used to estimate the cash flow resulting from these projects. If these projects include managerial flexibility (real options), a correct financial evaluation of these cash flow requires the use of real options methodology. We adapt prior work on real options valuation in the decision analysis literature to develop a methodology that avoids the need to estimate a risk-adjusted discount rate for the project with options. We illustrate this approach with a model drawn from the wind power industry, which is characterized by numerous uncertainties and high managerial flexibility. We conclude with a discussion comparing this methodology to the previous methods and describe under what conditions each one might be a more appropriate choice.