Bellalah et al (2007) - real options valuation within information uncetainty

Bellalah et al (2007) - real options valuation within information uncetainty

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INTERNATIONAL JOURNAL OF BUSINESS, 12(2), 2007 ISSN: 1083 4346 Real Options Valuation within Information Uncertainty: Some Extensions and New Results Mondher Bellalah a , A. Bouri b , and O. Levyne c a ISC Group Paris THEMA University de Cergy 33 boulevard du port 95 011 Cergy France Mondher.Bellalah@eco.u-cergy.fr b FSEG Sfax, Tunisie c ISC Group Paris France ABSTRACT This paper develops some results regarding the economic value added and real options. We use Merton’s (1987) model of capital market equilibrium with incomplete information to introduce information costs in the pricing of real assets. This model allows a new definition of the cost of capital in the presence of information uncertainty. Using the methodology in Bellalah (2001, 2002) for the pricing of real options, we extend the standard models to account for shadow costs of incomplete information. JEL Classification: G12, G20, G31 Keywords: EVA; Real options; Information costs * I would like to thank Professors Richard Roll, Giovanni Barone-Adesi and Robert Webb for their helpful comments. This paper benefits also from the comments of professors Gordon Sick, Lenos Trigeorgis and the participants in the real option conference in Cyprus, July 2002 and Paris 2005.
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268 Bellalah, Bouri, and Levyne I. INTRODUCTION Over the last two decades, a body of academic research takes the methodology used in financial option pricing and applies it to real options in what is well known as real options theory. This approach recognizes the importance of flexibility in business activities. Today, options are worth more than ever because of the new realities of the actual economy: information intensity, instantaneous communications, high volatility, etc. Financial models based on complete information might be inadequate to capture the complexity of rationality in action. As shown in Merton (1987), the "true" discounting rate for future risky cash flows must be coherent with his simple model of capital market equilibrium with incomplete information. This model can be used in the valuation of real assets 1 . Managers are interested not only in real options, but also in the latest outgrowth in DCF analysis; the Economic Value Added. EVA simply means that the company is earning more than its cost of capital on its projects. EVA is powerful in focusing senior management attention on shareholder value. Its main message concerns whether the company is earning more than the cost of capital. It says nothing about the future and on the way the companies can capitalize on different contingencies. Hence, a useful criterion must account for both the DCF analysis and real options. The NPV and the EP (economic profit) ignore the complex decision process in capital investment. In fact, business decisions are in general implemented through deferral, abandonment, expansion or in series of stages. This paper accounts for the effects of information costs in the valuation of derivatives as in Bellalah (2001).
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Bellalah et al (2007) - real options valuation within information uncetainty

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