Integrating Real Options with Decision Trees and Simulation
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Authors
Lewis, Neal
Eschenbach, Ted
Hartman, Joseph
Issue Date
2008-11-12
Type
Article
Language
en_US
Keywords
Engineering , Real options , Engineering management , Engineering economy , Decision tree , Sensitivity analysis , Simulation
Alternative Title
Abstract
Traditional tools to evaluate projects in the face of uncertainty include expected value analysis, decision trees, and simulation. In recent years considerable research has been devoted to the newer tool of real options analysis. However, the real world application of real options analysis remains limited, and there are a number of concerns regarding its use. We suggest that all of these tools should be presented in the graduate engineering economy course—in a way that shows their strengths and weaknesses.
One of the common complaints about real options is that the method often overstates the option value of a project. Recent work illustrates that this concern is well founded; most of the applications reported in the literature fail to account for appropriate costs and provide an inflated option value which leads to overly optimistic conclusions. The present work supports the developing conclusion that simple real options (such as the option to delay) often offer few additional insights over traditional tools such as decision trees and simulation. The use of real options does not change most funding recommendations when real options are used correctly.
Description
Citation
Publisher
American Society for Engineering Management