Real Options Valuation - The Importance of Interest Rate Modelling in Theory and Practice

Managerial decision-making during the lifetime of a project can have im­ portant implications on project handling and its contribution to shareholder value. Traditional capital budgeting methods (in particular methods based on net present value) fail to capture the role of managerial degrees of free­ dom and therefore tend to lead to a systematic undervaluation of the project. In contrast, the real options approach to investment analysis characterizes decision-making flexibility in terms of (real) option rights which can be eval­ uated analogously to financial options using contingent-claims pricing tech­ niques widely used in capital markets. The research carried out by Marcus Schulmerich analyzes real options for n- constant and stochastic interest rates versus constant interest rates. Analyzing stochastic interest rates in the context of real options valuation is of particular relevance given their long time to maturity which makes them more vulnera­ ble to interest rate risk than short-term financial options. To date, there has not been a comprehensive review of this issue in the academic literature. The fact that interest rates have fiuctuated widely over the recent years further highlights the need for studying this issue.